Peering Through the Legal Prism: When Asset Protection Becomes Fraudulent

VIEW IN PDFTax News & Comment — August 2011

I.  Introduction

English law addressing fraudulent conveyances dates back to the early Middle Ages. The first comprehensive attempt to prohibit such transfers appeared in the Fraudulent Conveyances Act of 1571, known as the “Statute of Elizabeth.” The Act was promulgated by Elizabeth I, daughter of Henry VIII from his second marriage to the ill-fated Anne Boleyn. The statute forbade feigned, covinous and fraudulent transfers of land and personalty entered into with the intent to delay, hinder or defraud creditors and others of their just and lawful claims.

The Statute provided that such conveyances were “clearly and utterly void, frustrate and of no effect” as against “creditors and others” whose claims might be hindered by such conveyances.

Today, as in the Middle Ages, conveyances which defeat claims of existing creditors may be challenged as being fraudulent. Asset protection is the “good witch” of asset transfers, wherein one legitimately arranges one’s assets so as to render them impervious to creditor attack. Asset protection is best implemented before a creditor appears, since a transfer made with the intent to hinder, delay or defraud a creditor may be deemed a fraudulent conveyance subject to rescission. Asset protection in its most elementary form might consist of merely gifting or consuming the asset.

Gifts made outright or to an irrevocable trust provide asset protection, assuming the transfer is bona fide. In property law, a gift requires three elements: First, the donor must intend to make a gift. Second, the donor must deliver the gift to the donee. Third, the donee must accept the gift. Whether these requirements have been met is a question of local law. (Although the IRS has dispensed with the requirement of donative intent to impose gift tax, most courts have not.)

Gifts should be delivered and be evidenced by a writing. Although transfers to family members are presumed to have donative intent, creditors may argue that the donee family member is merely holding legal title in trust or as nominee for the donor. For this reason, intrafamily gifts should be evidenced by a formal writing in which the donee accepts the gift.

Delivery of personal property should be accompanied by a written instrument. Delivery of real property requires a deed, and delivery of intangible personal property should be accompanied by an assignment or other legal document. Ownership of some intangibles, such as securities, may be accomplished by registering the securities in the name of the donee.

The retention by the donor of possession of property may suggest the absence of a gift, since no gift occurs where trustee, agent or bailee retains possession of the property. Similarly, asking a family member or a friend to “hold” property to protect against the enforcement of a known judgment creditor’s claim until the threat disappears would be subject to being declared fraudulent, since the motive for the transfer will have lacked donative intent.

Operating a business in corporate form, entering into a prenuptial agreement, executing a disclaimer, or even giving effect to a spendthrift trust provision, are common examples of asset protection which present few legal or ethical issues, primarily because such transfers do not defeat rights of known creditors. However, transferring assets into a corporation solely to avoid a personal money judgment, or utilizing an offshore trust solely to avoid alimony or child support payments, would defeat the rights of legitimate creditors, and would thereby constitute fraudulent transfers.

Businesses have traditionally limited exposure to liability by forming corporations. The limited liability of corporate shareholders has existed since 1602 when the Dutch East India Company was chartered to engage in spice trade in Asia. Yet the liability protection offered by corporate form can be negated, and the corporate veil “pierced,” if the corporation is undercapitalized.

Other business entities, such as LLCs and partnerships, also offer asset protection. Claims made against these entities, like claims made against corporations, do not “migrate” to the member or partner. A judgment creditor of a partner cannot seize the debtor’s partnership interest, but is limited to obtaining a “charging order.”
A charging order is a lien against the partner’s partnership interest.

A judgment creditor holding a charging order “stands in the shoes” of the partner with respect to partnership distributions. Therefore, if the partnership makes no distributions, the judgment creditor who has seized the partner’s interest may be charged with “phantom” income. This may cause the value of the creditor’s claim to be greatly diminished.

Disclaimers may be effective in avoiding creditor claims and are generally not fraudulent transfers under New York law. In New York, one may validly disclaim property and may thereby place the asset beyond the reach of creditors. The IRS may reach disclaimed property to satisfy a federal tax lien.

Certain powers of appointment possess asset protection features.  Limited powers of appointment are beyond creditors’ claims since the power holder has no beneficial interest in the power. Presently exercisable general powers of appointment, by contrast, in New York at least, are subject to creditors claims since the power holder has the right to appoint the property to himself. EPTL § 10-7.2.

II.    Ethical Considerations

Ethical considerations reach their zenith when asset protection is being contemplated. The obligation of an attorney to zealously represent the interests of his client is unquestioned. The ABA Model Code of Professional Conduct, DR 7-101, “Representing a Client Zealously,” provides that

A lawyer shall not intentionally fail to seek lawful objectives of his client through reasonable available means permitted by law and the Disciplinary Rules.

The Second Circuit has held that “[a] lawyer is authorized to practice his profession, to advise his clients, and to interpose any defense or supposed defense without making himself liable for damages.” Newburger, Loeb & Co. v. Gross, 563 F.2d 1057, 1080 (2nd Cir. 1977), cert. denied, 434 U.S. 1035 (1978).

Nevertheless, the ABA Model Code of Professional Conduct, DR 7-102, “Representing a Client Within the Bounds of the Law,” provides that “[a] lawyer shall not . . . [c]ounsel or assist his client in conduct that the lawyer knows to be illegal or fraudulent.”

Although the Model Code does not define “fraud,” New York, a Model Code jurisdiction, has provided that the term

does not include conduct, although characterized as fraudulent by statute or administrative rule, which lacks an element of scienter, deceit, intent to mislead, or knowing failure to correct misrepresentations which can be reasonably expected to induce detrimental reliance by another.

Therefore, in New York, the prohibition against counseling a client in perpetrating a “fraud” would apparently not prohibit an attorney from assisting a client in transferring property because of the possibility that the transfer might, in hindsight, be determined to have constituted a fraudulent conveyance.

Model Rule 8.4 of the ABA Model Rules of Professional Conduct provides that it is professional misconduct for a lawyer to “engage in conduct involving dishonesty, fraud, deceit or misrepresentation.” Model Rule 4.4 provides that “a lawyer shall not use means that have no substantial purpose other than to embarrass, delay, or burden a third person.”

Conduct involving dishonesty or an attempt to deceive appears to be a readily determinable question of fact. However, conduct employing means having no substantial purpose other than to delay or burden third parties may be a more difficult factual determination.

Connecticut Informal Opinion 91-23 states that

[f]raudulent transfers delay and burden those creditors who would be inclined to try and satisfy their unpaid debts from property of the debtor. It forces them to choose either not to challenge the transfer and suffer the loss of an uncollected debt or to file an action to set aside the transfer…If there is no other substantial purpose, Rule 4.4 applies. Where there is another substantial purpose, Rule 4.4 does not apply. For example, where there is a demonstrable and lawful estate planning purpose to the transfer Rule 4.4 would not, in out view apply.

An attorney is therefore ethically and legally permitted to provide counsel in the protection of a client’s assets. Since most prohibitions on attorneys involve the attorney having acted “knowingly,” due diligence is important to avoid ethical or legal problems. The counselor should determine (i) the source of the client’s wealth; (ii) the client’s reason for seeking advice concerning asset protection; and (iii) whether the client has any current creditor issues or is merely insuring against as yet unknown future creditor risks.

The client is also under an obligation to be truthful. Accordingly, the client should affirm that (i) it has no pending or threatened claims; (ii) it is not under investigation by the government; (iii) it will remain solvent following any intended transfers; and (iv) it has not derived from unlawful activities any of the assets to be transferred.

III. Uniform Fraudulent

    Transfer & Conveyance Acts

The definition of fraudulent transfer has remained fairly constant since the Statute of Elizabeth. While the common law doctrine of res judicata has influenced domestic courts in interpreting the common law of fraudulent conveyances, most states have chosen to codify the law. The Uniform Fraudulent Transfer Act defines the term “transfer” as

every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes the payment of money, release, lease, and creation of a lien or other encumbrance.

The Uniform Fraudulent Conveyance Act, the successor to the Uniform Fraudulent Transfer Act, defines a creditor as “a person having any claim, whether matured or unmatured, liquidated or unliquidated, absolute, fixed or contingent.” The Act defines the term “claim” as “a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured.” (New York is among six states that have enacted the Uniform Fraudulent Transfer Act, but not the Uniform Fraudulent Conveyance Act.)

IV.     Decisional Law

Although ample statutory authority exists, courts are often called upon to apply the common law in decide whether a conveyance is fraudulent. The doctrine of staré decisis,  which recognizes the significance of legal precedent, plays a paramount role in the evolving law governing asset transfers.

The Supreme Court, in Mexicano de Desarollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308, held that an owner of property has an almost absolute right to dispose of that  property, provided that the disposition does not prejudice existing creditors. Federal courts are without power to grant pre-judgment attachments since (i) legal remedies must be exhausted prior to equitable remedies; and (ii) a general (pre-judgment) creditor has no “cognizable interest” that would permit the creditor to interfere with the debtor’s ownership rights.

In determining whether a transfer is fraudulent, New York courts have made a distinction between future and existing creditors. Klein v. Klein, 112 N.Y.S.2d 546 (1952) held that the act of transferring title to the spouse of a police officer to eliminate the threat of a future lawsuit against the officer arising by virtue of the nature of his office was appropriate, and “amounted to nothing more than insurance against a possible disaster.”

Similarly, in Pagano v. Pagano, 161 Misc.2d 369, 613 N.Y.S.2d 809 (N.Y. Sur. 1994), family members transferred property to another family member who was not engaged in business. The Surrogate found there was no fraudulent intent and that

transfers made prior to embarking on a business in order to keep property free of claims that may arise out of the business does not create a claim of substance by a future creditor.

The New York County Surrogates Court, in In re Joseph Heller Inter Vivos Trust, 613 N.Y.S.2d 809 (1994), approved a trustee’s application to sever an inter vivos trust for the purpose of

insulat[ing] the trust’s substantial cash and securities from potential creditor’s claims that could arise from the trust’s real property.

The Surrogate observed that

New York law recognizes the right of individuals to arrange their affairs so as to limited their liability to creditors, including the holding of assets in corporate form…making irrevocable transfers of their assets, outright or in trust, as long as such transfers are not in fraud of existing creditors.

V.   Establishing Fraudulent Intent

Intent is subjective and proving it is difficult. Direct evidence of fraudulent intent, such as an email or a tape, is not likely to exist. Courts have therefore resorted to circumstantial evidence in the form of “badges of fraud.” Whether badges of fraud exist is determined by assessing (i) the solvency of the debtor immediately following the transfer; (ii) whether the debtor was sued or threatened with suit prior to the transfer; and (iii) whether the debtor transferred property to his or her spouse, while retaining the use or enjoyment of the property.

Under NY Debt. & Cred. Law § 273-a, a conveyance made by a debtor against whom a money judgment exists is presumed to be fraudulent if the defendant fails to satisfy the judgment. Transfers in trust at one time were, but are no longer, considered a badge of fraud. However, transfers in trust may implicate a badge of fraud if the transferor retains enjoyment of the transferred property.

Once the existence of a fraudulent transfer has been established, the Uniform Fraudulent Transfer Act provides that the creditor may (i) void the transfer to the extent necessary to satisfy the claim; (ii) seek to attach the property; (iii) seek an injunction barring further transfer of the property; or, if a claim has already been reduced to judgment, (iv) levy on the property.  Under the Act, “a debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets at a fair valuation.”

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.

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.” However, once the determination has been made that the transfer is not fraudulent, later events which might have rendered the transaction fraudulent would be of no legal moment.

The transfer of assets by a person against whom a meritorious claim has been made — even if not reduced to judgment — could render the transfer voidable. If the claim is not meritorious, then the transfer would probably not be fraudulent, regardless of its eventual disposition. For example, transferring title in the marital residence to a spouse could be a valid asset protection strategy, but doing so immediately after the IRS has filed a tax lien would likely result in the IRS seeking to void the transfer. However, if the IRS tax lien was erroneously filed, then the IRS could not properly seek to vitiate the transfer.

Gratuitous transfers are susceptible to being characterized as fraudulent in cases where the transferor appears to remain the equitable owner of the property. Accordingly, transfers between or among family members, or transfers to a partnership for little or no consideration, may carry with them the suggestion of fraudulent intent. In this vein, even a legitimate sale, if evidenced only by a flimsy, hastily prepared document, suggests an element of immediacy or unenforceability, which could in turn support a finding of fraud.

VI.    Asset Protection in Marriage

New York recognizes the existence of “separate” as well as “marital” property in the estate of marriage. Neither the property nor the income from separate property may be seized by a creditor of one spouse to satisfy the debts of the other spouse. Therefore, property may properly be titled or retitled in the name of the spouse with less creditor risk. Provided the transfer creating separate property is made before the assertion of a valid claim, creditors of the transferring spouse should be prevented from asserting claims against the property.

In contrast to protection afforded by separate property, marital property is subject to claims of creditors of either spouse. Whether property constitutes marital property or separate property may involve tracing the flow of money or property. Property received by gift or inheritance is separate property, and is generally protected from claims made against the other spouse (or from claims made by the other spouse). Combining separate property or funds of the spouses will transform separate property into marital property.

Common law recognizes the right of married persons to enjoy enhanced asset protection if title is held jointly between the spouses in a tenancy by the entirety, a unique form of title available only to married persons. U.S. v. Gurley, 415 F.2d 144, 149 (5th Cir. 1969) observed that “[a]n estate by the entireties is an almost metaphysical concept which developed at the common law from the Biblical declaration that a man and his wife are one.”

First codified in 1896, EPTL § 6-2.2 recognizes the tenancy by the entirety, where title is vested in the married couple jointly and each spouse possesses an undivided interest in the entire property. Provided the couple remains married, the survivorship right of either spouse cannot be terminated. Nor may spouse can unilaterally sever or sell his or her portion without the consent of the other. However, divorce will automatically convert a tenancy by the entirety to a joint tenancy.

The ability to prevent creditors of one spouse from reaching, attaching and possibly selling marital property held in a tenancy by the entirety is a unique and important attribute of the marital estate. Creditors cannot execute a judgment on property held by spouses in a tenancy by the entirety. New York cases have held that a receiver in bankruptcy cannot reach or sever ownership when title is by the entirety. Although coop ownership is technically the ownership of securities and not real estate, ownership by married couples of coops as tenants by the entirety is now the default method of holding title in a coop.

Not all property held in a tenancy by the entirety is protected from claims of creditors. The IRS, a creditor with enhanced rights, has succeeded in defeating the protection normally accorded by holding property in a tenancy by the entirety. In Craft v. U.S., 535 U.S. 274 (2002), the Supreme Court held that a federal tax lien could attach even to an interest held by one spouse as a tenant by the entirety.

Marriage may also present situations where the spouses themselves assume a creditor and debtor relationship. Prenuptial and postnuptial agreements define the rights and obligations of spouses between themselves, both during and after a divorce. Many statutory rights may be waived, changed or enhanced by agreement. Other rights not provided by statute may be conferred upon a party by a pre or post-nuptial agreement.

A prenuptial agreement may attempt to alter the rights of persons not a party to the agreement. Thus, parties could designate certain property as separate property in the event of a divorce. However, such an executory contract (i.e., not performed) would not necessarily be binding on a third party, and might be successfully avoided, for example, by a trustee in bankruptcy.

Some retirement benefits, such as IRA benefits, may be waived in a prenuptial agreement. However, retirement benefits subject to ERISA may not be waived prior to marriage. If a waiver of ERISA benefits is contemplated in a prenuptial agreement, the agreement should contain a provision requiring the waiving party to execute a waiver after marriage. If the waiver does not occur following marriage, the waiver of retirements benefits subject to ERISA will be ineffective.

VII. Joint Tenancies and

         Tenancies in Common

Joint tenancies and tenancies in common offer little asset protection. The joint tenancy is similar to a tenancy by the entirety in that each joint tenant owns an undivided interest, and each possesses the right of survivorship. However, unlike property held by spouses as tenants by the entirety, each joint tenant may pledge or transfer his interest without the consent of the other, since there is no “unity of ownership.” Such a transfer would create a tenancy in common.

Another distinction between the tenancy by the entirety and the joint tenancy is that a joint tenant’s interest is subject to attachment by creditors and by the Bankruptcy Court. If attachment occurs, the joint tenancy can be terminated and the property can divided or, more likely, partitioned, with the proceeds being divided between the unencumbered joint tenant and the creditor or trustee in bankruptcy. Note that although a tenancy by the entirety is presumed to be the manner in which married persons hold title, married persons may also hold title as joint tenants, or as tenants in common.

For this reason, deeds should be clear as to the type of tenancy in which the property owned by spouses is being held. A deed stating that title is held by “husband and wife, as joint tenants,” would imply the existence of a joint tenancy but, because of the phrase “husband and wife,” could also be interpreted as creating a tenancy by the entirety.

The tenancy in common provides little asset protection. Each tenant in common is deemed to hold title to an undivided interest in the property that each may dispose of by sale, gift or bequest. No right of survivorship exists, nor is there a unity of ownership, as in a tenancy by the entirety. Tenants in common share a right of possession. Thus, one tenant in common could transfer an interest in real property to a third party who could demand concurrent possession. An unwilling tenant in common could prevent such an eventuality by forcing a partition sale.

The interest of a debtor tenant in common is subject to attachment by judgment creditors and the Bankruptcy Court. The only real asset protection accorded by the tenancy in common is the time and expense a creditor would be required to expend in commencing a partition sale to free up liquidity in the property seized.

VIII.    Protecting The Residence

New York affords little protection to the homestead against claims made by creditors. CPLR 5206(a) provides that amount of equity in the debtor’s homestead shielded from judgment creditors and from the bankruptcy trustee is $50,000. Married couples in co-ownership may each claim a $50,000 exemption where a joint bankruptcy petition is filed, creating a $100,000 exemption.

Although little statutory protection is provided for by the legislature, the Department of Taxation and Finance has shown little inclination to foreclose on a personal residence of a New York resident to satisfy unpaid tax liabilities. The IRS, perhaps reflecting its federal charter, has shown slightly less disinclination to foreclose in this situation, although in fairness it should be noted that the IRS infrequently commences foreclosure proceedings on a residence to satisfy a tax lien. On the other hand, both the IRS and New York State could be expected to record a tax lien which would secure the government’s interest in the event the property were sold or refinanced.

Some states, such as Florida and Texas, provide for a liberal homestead exemption. The homestead exemption in Florida is unlimited, provided the property is no larger than one-half acre within a city, or 160 acres outside of a municipality. The Florida Supreme Court has held that the homestead exemption found in Florida’s Constitution even protects homes purchased with nonexempt funds for the purpose of defrauding creditors in violation of Florida statute.  Havoco of America, Ltd., v. Hill, 790 So.2d 1018 (Fla. 2001).

Since a residence is often a significant family asset, in jurisdictions such as Florida, the debtor’s equity in the homestead may be increased to a large amount. This protection was availed of by Mr. Simpson after a large civil judgment was rendered against him in California.

In jurisdictions such as New York, which confer little protection to the residence, a qualified personal residence trust (QPRT) may serve as a proxy. A QPRT results when an interest in real property, which could be attached by a creditor, is converted into a mere right to reside in the residence for a term of years. A (QPRT) is often used to maximize the settlor’s unified credit for estate planning purposes.

The asset protection feature of a QPRT derives directly from the diminution of rights in the property retained by the putative debtor-to-be. The asset protection benefit of creating a QPRT is that the settlor’s interest in the property is changed from a fee interest subject to foreclosure and sale, to a right to continue to live in the residence, which is not. If the settlor’s spouse has a concurrent right to live in the residence, a creditor would probably have no recourse. Some litigation involving QPRT property has arisen in New York.

IX. Federal Bankruptcy Exemptions

Under Section 522 of the Federal Bankruptcy Code, certain “exempt” items will be unavailable to creditors in the event of bankruptcy. Individual states are given the ability to “opt out” of the federal exemption scheme, or to permit the debtor to choose the federal exemption scheme or the state’s own exemption statute. New York has chosen to require its residents to opt out of the federal scheme, and has provided its own set of exemptions. Nevertheless, some exemptions provided for by federal law cannot be overridden by state law.

Exemptions found in federal law also occur outside of the Federal Bankruptcy Code may also be used by a debtor. These include (i) wage exemptions; (ii) social security benefits; (iii) civil service benefits; (iv) veterans benefits; and (v) qualified plans under ERISA. Thus, federal bankruptcy law automatically exempts virtually all tax-exempt pensions and retirement savings accounts from bankruptcy, even if state law exemptions are used.

Federal law protects any pension or retirement fund that qualifies for tax treatment under IRC Sections 401, 402, 403, 408, or 408A. IRAs qualify under IRC § 408. Qualified plans under ERISA enjoy special asset protection status. Under the federal law, funds so held are protected from creditors of the plan participant. Patterson v. Shumate, 504 U.S. 753 (1992). The protection offered by federal statute is paramount, and may not be diminished by state spendthrift trust law.

X.    New York Exemptions

The objective in pre-bankruptcy planning is to make maximum use of available exemptions. At times, this involves converting non-exempt property into exempt property. While pre-bankruptcy planning could itself rise to the level of a fraud against existing creditors, since the raison d’etre of exemptions is to permit such planning, only in an extreme case would an allegation of fraud likely be upheld.

New York has in some cases legislated permissible exemption planning by providing windows of time in which pre-bankruptcy exemption planning is permissible. Under ERISA, most qualified plans are required to include a spendthrift provision. Accordingly, most qualified plans will be asset protected with respect to state law proceedings, and will be excluded from the debtor’s bankruptcy estate. See CPLR § 5205(c), Debt. & Cred. Law § 282(2)(e).

New York (as well as New Jersey and Connecticut) exempts 100 percent of undistributed IRA assets. Non-rollover IRAs are exempt from being applied to creditors’ claims pursuant to CPLR 5205, which denotes them as personal property.

EPTL §7-1.5(a)(2) provides that proceeds of a life insurance policy held in trust will not be “subject to encumbrance” provided the trust agreement so provides. Similarly, Ins. Law §3212(b) protects life insurance proceeds provided the trust contains language prohibiting the proceeds from being used to pay the beneficiary’s creditors. Ins. Law §3212(c) protects life insurance proceeds if the beneficiary is not the debtor, or if the debtor’s spouse purchases the policy.

Ins. Law §3212(d) at first blush is appealing, as it provides for an unlimited exemption for benefits under an annuity contract. However, upon closer examination paragraph (d)(2) further provides that “the court may order the annuitant to pay to a judgment creditor . . . a portion of such benefits that appears just and property . . . with due regard for the reasonable requirements of the judgment debtor.”

Debt. & Cred. Law §283(1) circumscribes the protection accorded to annuities, by limiting the exemption for annuity contracts purchased within six months of a bankruptcy filing to $5,000, without regard to the “reasonable income requirements of the debtor and his or her dependents.”

CPLR §5205(d) provides that the following personal property is exempt from application to satisfy a money judgment, except such part as a court determines to be unnecessary for the reasonable requirements of the judgment debtor and his dependents:

(i) ninety percent of the earnings of the judgment debtor for personal services rendered within sixty days before, and any time after, an income execution. (Since the exemption applies to employees, income derived from self-employment may not be excluded);

(ii) ninety percent of income or other payments from a trust the principal of which is not self-settled;

(iii) payments made pursuant to an award in a matrimonial action for support of the spouse or for child support, except to the extent such payments are “unnecessary”; and

(iv) property serving as collateral for a purchase-money loan (e.g., car loan or a home securing a first mortgage) in an action for repossession.

XI.     Trusts

The concept of trusts dates back to the 11th Century, at the time of the Norman invasion of England. Trusts emerged under the common law as a device which minimized the impact of inheritance taxes arising from transfers at death. The purpose of the trust was to separate “legal” title, which was given to the “trustee,” from “equitable title,” which was retained by the trust beneficiaries. Since legal title remained in the trustee at the death of the grantor, transfer taxes were thus avoided.

The trust has since evolved in common law countries throughout the world. Trusts today serve myriad functions including, but not limited to, the function of reducing estate taxes. The basic structure of a trust is that (i) a settlor (either an individual or a corporation), establishes the trust agreement; (ii) the trustee takes legal title to and administers the assets transferred into the trust; and (iii) beneficiaries receive trust distributions.

Trusts are ubiquitous in estate planning, both for nontax as well as tax reasons. For example, trusts are employed as a means to protect immature or spendthrift beneficiaries. Inter vivos trusts also enable the grantor to retain considerable control over the trust property. Testamentary trusts contained in wills enable the testator to control the manner in which the estate will be distributed to heirs.

Trusts also possess significant asset protection attributes. Since trusts may be employed for diverse and legitimate reasons, they are not typically thought of as a device employed with an intent to hinder, delay or defraud creditors. However effective trusts are at protecting against creditor claims, once trust assets are distributed to beneficiaries, the beneficiary holds legal title to the property. At that point, creditor protection may be lost.

Asset protection features of an irrevocable trust may arise by virtue of a discretionary distribution provision, also known as a “sprinkling” trust. For example, the trust may provide that the trustees

in their sole and absolute discretion may pay or apply the whole, any portion, or none of the net income for the benefit of the beneficiaries.

Alternatively, the trustees’ discretion may be limited by a broadly defined standard, i.e.,

so much of the net income as the Trustees deem advisable to provide for the support, maintenance and health of the beneficiary.

The effects of a discretionary distribution provision on the rights of a creditor are profound. The rights of a creditor can be no greater than the rights of a beneficiary. Therefore, if the trust provides that the beneficiary cannot compel the trustee to make distributions, neither could the creditor force distribution. Therefore, properly limiting the beneficiary’s right to income in the trust instrument may determine the extent to which trusts assets are protected from the claims of creditors.

Failure to properly limit the beneficiary’s right to income from a trust can also have deleterious tax consequences if the creditor is the IRS. TAM 0017665 stated that where the taxpayer had a right to so much of the net income of the trust as the trustee determined necessary for the taxpayer’s “health, maintenance, support and education,” the taxpayer had an identifiable property interest subject to a federal tax lien. Since the discretion of the trustee was broadly defined and subject to an “ascertainable standard” rather than being absolute, the asset protection of the trust was diminished.

 A trustee who is granted absolute discretion in the trust instrument to make decisions regarding trust distributions, and who withholds distributions to a beneficiary with a judgment creditor, is not acting fraudulently vis à vis the creditor. To the contrary, the trustee is properly fulfilling his fiduciary responsibilities. However, in some cases, a court may compel a trustee to make distributions. In such cases, the trustee could be faced with possible contempt if he refused to comply with the court’s order. To make the trustee’s office even more difficult, the trustee could be faced with competing directives from different courts.

Many settlors choose to incorporate mandatory distribution provisions which provide for outright transfers to children or their issue at pretermined ages. Yet, holding assets in trust for longer periods may be preferable, since creditor protection can then be continued indefinitely. Holding a child’s interest in trust for a longer period may be prudent in a marriage situation. Assets held in a trust funded either by the spouse or by the parent stand a greater chance of being protected in the event of divorce than assets distributed outright to the spouse, even if the beneficiary-spouse does not “commingle” these separate  assets with marital assets.

If the trust provides for a distribution of principal upon the beneficiary’s reaching a certain age, e.g., 35 or 40, the inclusion of a “hold-back” provision allowing the Trustee to withhold distributions in the event a beneficiary is threatened by a creditor claims, may be advisable.

XII.    Implied Trusts

Express trusts are those which are memorialized and formally executed. However, trusts may also be implied in law. An implied “resulting trust” arises where the person who transfers title also paid for the property, and it is clear from the circumstances that such person did not intend to transfer beneficial interest in the property. Parol evidence may be used to demonstrate the existence of a resulting trust.

Thus, a parent who makes car payments under a contract in the child’s name will not hold legal title, but would likely possess equitable title. Since creditors of the parent “stand in the shoes” of the parent, they might be capable of asserting rights against the child who holds “bare” legal title. Even if the child had no knowledge of the parent’s creditor, the creditor could be entitled to restitution of the asset. Rogers v. Rogers, 63 NY2d 582, 483 NYS2d 976 (1984).

A “constructive trust” arises where equity intervenes protect the rightful owner from the holder of legal title, where legal title was acquired through fraud, duress, undue influence, mistake, breach of fiduciary duty, or other wrongful act, and the wrongful owner is unjust enriched. In New York, a constructive trust requires the following four conditions: (i) a fiduciary or confidential relationship; (ii) a promise; (iii) a transfer in reliance on the promise; and (iv) unjust enrichment.

A transfer made to avoid an obligation owed to a creditor will constitute a fraudulent transfer. In many cases, no consideration will have been paid to a transferee who agrees to hold legal title for the transferor to avoid the claims of the transferor’s creditor.  If the scheme is not uncovered, and the transferor attempts to regain title from the transferee, a constructive trust would in theory arise, since the four conditions for establishing a constructive trust would exist.

However, the constructive trust is an equitable remedy. Courts sitting in equity are generally loathe to allow one with “unclean hands” to profit. Therefore, most courts would refuse to imply a trust in favor of the transferor where the transfer was made for illegal purposes. However, the same court might well imply a constructive trust in favor of the legitimate creditors of the transferor in this case.

Occasionally, a person will establish a “mirror” trusts with another person, hoping to achieve asset protection by indirect means. However, such arrangements are likely to fail. Thus, “reciprocal” or “crossed” trust arrangements, in which the settlor of one trust is the beneficiary of another, would likely offer little or no asset protection. In fact, the “reciprocal trust doctrine” has been invoked by the IRS to defeat attempts by taxpayers to shift assets out of their estates.

XIII. Tax Issues Associated with

         Asset Protection Trusts

It is inadvisable fot the settlor to name himself as trustee of an irrevocable trust, unless the settlor has retained virtually no rights under the trust. The settlor’s retained right to determine beneficial enjoyment could well cause estate tax inclusion under IRC §§ 2036 and 2038. However, a settlor will not be deemed to have retained control for estate tax purposes merely because the trustee is related to the settlor. Therefore, the settlor’s spouse or children may be named as trustees without risking estate tax inclusion.

To avoid estate tax problems for a beneficiary named as trustee, the powers granted to the beneficiary should be limited. A beneficiary’s right to make distributions to herself without an ascertainable standard limitation would constitute a general power of appointment under Code Sec. 2041, and would result in inclusion in the beneficiary’s estate. The beneficiary’s power to make discretionary distributions would also decimate creditor protection. To avoid this problem, an independent trustee should be appointed to exercise the power to make decisions regarding distributions to that beneficiary.

EPTL §10-10.1 prevents inadvertent estate tax fiascos by statutorily prohibiting a beneficiary from making decisions regarding discretionary distributions to himself. Therefore, even if the beneficiary were named sole trustee of a trust providing for discretionary distributions, the statute would require another trustee to be appointed to determine distributions to the beneficiary. Note that in this case the beneficiary could continue to act as trustee for other purposes of the trust, and could continue to make decisions regarding distributions to other beneficiaries.

If the beneficiary has unlimited right to the trust, regardless of who is the trustee, inclusion could result under IRC § 2036. It is the retained right — and not the actual distribution —  that causes inclusion. PLR 200944002 stated that a trustee’s authority to make discretionary distributions to the grantor will not by itself result in  inclusion under IRC §2036. Thus, a trust which grants the trustee the authority to make distributions to the settlor, but vests in the settlor no rights to such distributions, might result in IRC § 2036 problems being avoided.

XIV.     Spendthrift Trusts

Trust assets can be placed beyond the reach of beneficiaries’ creditors by use of a “spendthrift” provision. The Supreme Court, in Nichols v. Eaton, 91 U.S. 716 (1875), recognized the validity of a spendthrift trust, holding that an individual should be able to transfer property subject to certain limiting conditions.

A spendthrift clause provides that the trust estate shall not be subject to any debt or judgment of the beneficiary, thus preventing the beneficiary from voluntarily or involuntarily alienating his interest in the trust. The rationale behind the effectiveness of a spendthrift provision is that the beneficiary possesses an equitable, but not a legal, interest in trust property. Therefore, creditors of a beneficiary should not be able to assert legal claims against the beneficiary’s equitable interest in trust assets.

Even if the trust instrument provides that the trustee’s discretion is absolute, the trust should contain a spendthrift clause. It is not enough for asset protection purposes that a creditor be unable to compel a distribution. The creditor must also be unable to attach the beneficiary’s interest in the trust.

A spendthrift trust may protect a beneficiary from (i) his own profligacy or immaturity; (ii) his bankruptcy; (iii) some of his torts; (iv) many of his creditors; and (v) possibly his spouse. No specific language is necessary to create a spendthrift trust. A spendthrift limitation may even be inferred from the intent of the settlor. Still, it is preferable as well as customary to include spendthrift language in a trust.

A spendthrift provision may also provide that required trust distributions become discretionary upon the occurrence of an event or contingency specified in the trust. Thus, a trust providing for regular distributions to beneficiaries might also provide that such distributions would be suspended in the event a creditor threat appears. Most wills containing trusts incorporate a spendthrift provision.

Some exceptions to spendthrift trust protection are in the nature of public policy exceptions. Thus, spendthrift trust assets may be reached to enforce a child support claim against the beneficiary. Courts could also invalidate a spendthrift provision to satisfy a judgment arising from an intentional tort. A spendthrift trust would likely be ineffective against a government claim relating to taxes, since public policy considerations in favor of the collection of tax may outweigh the public policy of enforcing spendthrift trusts.

XV.  Self-Settled Spendthrift Trusts

At common law, a settlor could not establish a trust for his own benefit, thereby insulating trust assets from claims of own creditors. Such a “self-settled” spendthrift trust would arise where the person creating the trust also names himself a beneficiary of the trust. Under common law, the assets of such a trust would be available to satisfy creditor claims to the same extent the property interest would be available to the person creating the trust. Thus, one could not fund a trust with $1,000, name himself as sole beneficiary, and expect to achieve creditor protection. This is true whether or not the settler also named himself as trustee.

Prior to 1997, neither the common law nor the statutory law of any state permitted a self-settled trust to be endowed with spendthrift trust protection. However, since 1997, five states, including Delaware and Alaska, have enacted legislation which expressly authorizes self-settled spendthrift trusts. If established in one of these jurisdictions, a self-settled spendthrift trust could allow an individual to put assets beyond the reach of future, and in some cases even existing, creditors while retaining the right to benefit from trust assets.

These few states now compete with exotic locales such as the Cayman and Cook Islands, and with less exotic places, such as Bermuda and Lichtenstein, which for many years have been a haven for those seeking the protection that only a self-settled spendthrift trust can offer.

New York is not now, and has never been, a haven for those seeking to protect assets from claims of creditors. Most states, including New York, continue to abhor self-settled spendthrift trusts. This is true even if another person is named as trustee and even the trust is not created with an intent to defraud existing creditors. New York’s strong public policy against self-settled spendthrift trusts is evident in EPTL §7-3.1, which provides:

A disposition in trust for the use of the creator is void as against the existing or subsequent creditors of the creator.

Still, there appears to be no reason why a New York resident could not transfer assets to the trustee of a self-settled spendthrift trust formed in Delaware or in another state which now permits such trusts. Even though a New York Surrogate or Supreme Court judge might view with skepticism an asset protection trust created in Delaware invoked to protect against judgments rendered in New York, the Full Faith and Credit Clause of the Constitution could impart significant protection to the Delaware trust.

If a self-settled spendthrift trust is asset protected, the existence of creditor protection would also likely eliminate the possibility of estate inclusion under IRC §2036. This is so because assets placed beyond the reach of creditors are generally also considered to have been effectively transferred for federal transfer tax purposes.

XVI. Delaware Asset

        Protection Trusts

In 1997, Delaware enacted the “Qualified Dispositions in Trust Act.” Under the Act, a person may create an irrevocable Delaware trust whose assets are beyond the reach of the settlor’s creditors. However, the settlor may retain the right to receive income distributions and principal distributions subject to an ascertainable standard. By transferring assets to a Delaware trust, the settlor may be able to retain enjoyment of the trust assets while at the same time rendering those assets impervious to those creditor claims which are not timely interposed within the applicable period of limitations for commencing an action.

Delaware is an attractive trust jurisdiction for many reasons: First, it has eliminated the Rule Against Perpetuities for real estate; second, it imposes no tax on income or capital gains generated by an irrevocable trust; third, it has adopted the “prudent investor” rule, which accords the trustee wide latitude in making trust investments; fourth, it permits the use of “investment advisors” who may inform the trustee in investment decisions; and fifth, Delaware trusts are confidential, since Delaware courts do not supervise trust administration.

To implement a Delaware trust, a settlor must make a “qualified disposition” in trust, which is a disposition by the settlor to a “qualified trustee” by means of a trust instrument. A qualified trustee must be an individual other than the settlor who resides in Delaware, or an entity authorized by Delaware law to act as trustee. The trust instrument may name individual co-trustees who need not reside in Delaware. Delaware’s statute, 12 Del. C. § 3570 et seq., notes that it “is intended to maintain Delaware’s role as the most favored jurisdiction for the establishment of trusts.”

Although the trust must be irrevocable, the Settlor may retain the right to (i) veto distributions; (ii) exercise special powers of appointment; (iii) receive current income distributions; and (iv) receive principal distributions if limited to an ascertainable standard (e.g., health, maintenance, etc.).

The trust may designate investment advisors and “protectors” from whom the trustee must seek approval before making distributions or investments. Thus, the settlor, even though not a trustee, may indirectly retain the power to make investment decisions and participate in distribution decisions, even to himself.

Delaware trusts may also be structured so that the assets transferred are outside the settlor’s gross estate for estate tax purposes. If, instead of gifting the assets to the trust, a sale is made to a Delaware irrevocable “defective” grantor trust, the assets may be removed from the settlor’s estate at a reduced estate tax cost.

Delaware law governing Delaware trusts is entitled to full faith and credit in other states, a crucial advantage not shared by trusts created in offshore jurisdictions. The Delaware Act bars actions to enforce judgments entered elsewhere, and requires that any actions involving a Delaware trust be brought in Delaware. A New York court might therefore find it difficult to declare a transfer fraudulent if, under Delaware law, it was not. In any event, a Delaware court would not likely recognize a judgment obtained in a New York court with respect to Delaware trust assets.

Although the Full Faith and Credit Clause of the Constitution requires every state to respect the statutes and judgments of sister states, the Supreme Court, in Franchise Board of California v. Hyatt, 538 U.S. 488 (2003) held that it “does not compel a state to substitute the statutes of other states for which its own statutes dealing with a subject matter concerning which it is competent to legislate.” In Hanson v. Denckla, 357 U.S. 235 (1958), a landmark case, the Supreme Court held that Delaware was not required to give full faith and credit to a judgment of a Florida court that lacked jurisdiction over the trustee and the trust property.

The Delaware Act does not contain as short a limitations period as do most offshore jurisdictions. Under 12 Del. C. §§ 1304(a)(1) and 3572(b), a creditor’s claim against a Delaware trust is extinguished unless (i) the claim arose before the qualified disposition was made and the creditor brings suit within four years after the transfer was made or within 1 year after the transfer was or could reasonably have been discovered by the claimant; or (ii) the creditor’s claim arose after the transfer and the creditor brings suit within four years after the transfer, irrespective of the creditor’s knowledge of the transfer.

Although the Delaware statute affords more protection for creditors than do offshore trusts, the four-year period for commencing legal action reduces the risk that a creditor whose claim is time-barred could successfully assert that (i) a transfer was fraudulent notwithstanding the Act or (ii) the Act’s statute of limitations is itself unconstitutional.

A Delaware trust may also continue in perpetuity, at least with respect to real property. By contrast, New York retains the common law Rule Against Perpetuities, which limits trust duration to 21 years after the death of any person living at the creation of the trust. EPTL § 9-1.1.

XVII. Foreign Asset

Protection Trusts

The basic structure of an offshore trusts are the same as those of the domestic trust. Foreign trust jurisdictions go beyond Delaware Asset Protection Trusts in terms of the asset protection they offer, since they often possess the feature of short or nonexistent statutes of limitations for recognizing foreign (i.e., U.S.) judgments.

Although the IRS recognizes the bona fides of foreign asset protection trusts, it also seeks to tax such trusts. Because of the secrecy often associated with foreign trusts, the IRS may be unaware of the assets placed in a foreign trust. Foreign trusts are subject to strict reporting requirements by the IRS, with harsh penalties for failure to comply. Foreign asset protection trusts are not endowed with special tax attributes which by their nature legitimately reduce the incidence of U.S. income taxes.

Foreign trusts do accord a measure of privacy to the grantor, and may convey the impression that the creator of the trust is judgment-proof, even if that is not the case. A creditor 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.

On balance, since asset protection trusts may now be created in several states within the U.S., resort to a foreign jurisdiction to implement such a trust would now seem to be an inferior method of accomplishing that objective.

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