Domestic Asset-Protection Trusts Explained
In addition to asset protection, a DAPT can offer other benefits, including state income tax savings.
A domestic asset-protection trust (DAPT) is an irrevocable self-settled trust in which the grantor is designated a permissible beneficiary and allowed access to the funds in the trust account. If the DAPT is properly structured, the goal is that creditors won’t be able to reach the trust’s assets. In addition to providing asset protection, a DAPT offers other benefits, including state income tax savings when sitused in a no-income-tax state.
A DAPT is of no benefit until it’s funded with assets. Trust assets typically include: (1) cash, (2) securities, (3) limited liability companies (LLCs), (4) business assets like intellectual property, inventory and equipment, (5) real estate, and (6) recreational assets such as aircraft and boats. Each asset under consideration for transfer into a DAPT must be evaluated from different vantage points, including its effect on: legal protection, taxation, business and growth potential, and future distributions to spouses and heirs. Thus, the asset-transfer planning process is a critical area requiring the assemblage of a range of skills.
To withstand attack, a DAPT should be designed to have its most substantial relationship to the state where the trust is formed—not the settlor’s state of residence.1 In a closely contested legal battle, the location of the trust assets could be determinative. Consequently, on a case-by case basis, it’s wise to consider transferring the following assets into trust-state LLCs: (1) securities and cash accounts, (2) valuable and/or risky business and recreational assets, (3) real estate, and (4) settlor businesses.
In almost all cases, I recommend that securities be held in an LLC in a state with favorable privacy and LLC-protection laws. If the Settlors should only fund DAPTs with aLLC-held securities are to be placed in a DAPT, the LLC should be formed in the trust state.ssets having a long-term need horizon. This is particularly true for securities assets that, by nature, require careful management. Also, long-term investment is consistent with the concept that withdrawals from a DAPT should be carefully considered and infrequent.
Over the decades, we’ve learned there’s a tendency for clients to tilt toward the promise of higher return over lower risk. To overcome this potentially dangerous tendency, the investment process should begin with each client understanding and defining his or her acceptable risk parameters. Then, a long-hold portfolio can be developed that maximizes the return potential for the chosen level of risk.
Convenience is an important element in managing a DAPT. I’ve found it optimal to hold cash and all securities in a single investment account. Such an account will allow the trust to easily invest cash in a variety of safe and effective cash-equivalent vehicles, such as money market funds, treasury funds and short-term bond funds. To enhance the settlor’s substantial relationship to the trust state, it’s also helpful to hold a portion of the cash in a local bank.
Jurisdictional difficulties often arise with real estate assets because, of course, a parcel of land can’t be relocated to the trust state. It’s a legitimate concern that, if the LLC owns real property located in the client’s domicile state, a local court may try to exercise jurisdiction over the property, notwithstanding its out-of-state ownership. Restatement (Second) of Conflicts of Laws Section 276 provides that “the administration of a trust of an interest in land is supervised by the courts of the situs as long as the land remains subject to the trust.” With exceptions,2 case law generally supports this position. The best available solution may be to transfer ownership of the property into an LLC that’s formed in the trust state and owned by a land trust for privacy. Although this approach hasn’t been court-approved, it should be evaluated (for example, planners must consider matters such as state transfer taxes and mortgage-lender approval), as the weighing of risk and reward may well lead to the transfer being worthwhile. Whether in rem jurisdiction ultimately plays a part in the outcome will depend on the case’s specific facts and the LLC’s structure.
In most cases, the settlor’s business LLC will already be registered in his or her home state. Depending on the state, this may be problematic. To understand the concern, here's a little background on LLC protection.
All LLCs are designed to insulate their owners’ personal assets from claims arising from within their business. Without such protection, it would be too dangerous for entrepreneurs to invest capital in businesses with inherent risks. This concept, called “internal protection,” goes back to the industrial revolution and is a foundation of our commercial system. Traditional C corporations also provide internal protection, but they suffer from the double taxation of income. Contrarily, LLC income is directly passed through to its member owners and taxed only once. LLCs are also simpler to operate. Consequently, most entities formed today are LLCs.
Just as important, LLCs can provide external protection. Suppose you host a Christmas party for friends and an inebriated guest leaves the party and becomes involved in a car accident in which someone is injured or killed. As a “deep pocket,” you could be sued and, although you’re certain it wasn’t your fault, suffer a judgment for millions of dollars. This is where knowledgeable asset-protection planning comes into play. The plaintiff’s attorneys will find the task of seizing assets owned by a properly structured LLC in a legally favored state considerably more difficult.
LLC protection works like this. Generally, after a creditor obtains a personal judgment against a defendant, it becomes the creditor’s responsibility to identify the defendant’s assets, obtain a court order, and seize those assets adequately to satisfy the judgment. But, if properly planned, the LLC members’ interests won’t be treated like other assets. The creditor’s legal remedy will be limited to obtaining a lien, called a “charging order.” Charging orders allow the creditor to obtain a court lien against distributions made to the member’s interest; but they don’t allow the creditor to step into the defendant’s shoes and become a member of the LLC, with rights to its assets. Thus, if the LLC chooses not to distribute assets or income to its members, the assets won’t be available to the judgment creditor. Moreover, only the member owners are entitled to determine whether or when distributions will be made.
Most states’ laws don’t include the language needed for optimal LLC planning. For an LLC to be effective, it should be formed in one of just a few states with favorable LLC laws or in one of an even more limited number of states where true privacy can be ensured.
Equipped with a better understanding of LLC protection, let’s now revisit the question of whether clients who’ve formed LLCs to hold their business assets should transfer the LLC assets into a trust state LLC or leave them inside their home state LLC. Technically, there are several viable techniques available for making tax-free transfers of LLC assets into a new LLC formed in the trust state. The real question is whether courts will view the transfer as a ruse.
We know that, if the transfer is the result of an effort to hinder, delay or defraud a known or contemplated creditor, it can be reversed as a voidable transaction (fraudulent transfer). Later, in a legal challenge to the trust, the plaintiff may also raise theories such as “alter ego” and “piercing the corporate veil,” but these challenges already exist even if there’s no transfer. You can reduce such risks by maintaining and managing all LLCs with lawyerly attention. Assuming the transfer isn’t made to avoid an existing or foreseeable creditor, I see no reason why the transfer can’t be made. The legal issue should be strictly a matter of whether the transfer is a voidable transaction. So, in vetted cases, a reorganization of the LLC into the trust state may be a viable option that should be investigated.
Risky Vehicles and Similar Assets
High-risk assets, like jet skis, motor homes, boats, motorcycles, trailers and aircraft, generally should be held in one or more LLCs. Where appropriate, the LLC should be formed in the trust state and the member interest transferred into the trust state DAPT.
There are, however, important caveats to be made about LLC protection for this type of assets. The first is that, if the asset isn’t used for a business purpose (for example, airplane leasing), the LLC may be at a higher risk for a piercing the LLC veil claim. To reduce this concern, planners should consider using a multi-member LLC rather than a single-member LLC and encourage their clients to maintain meticulous documentation and tax reporting.
A second caveat surrounds potential liability claims. Even though the vehicle or other asset is held in an LLC, an injured plaintiff may claim that the client transferor is individually liable if he caused or contributed to the negligent act. An example would be if the client were pulling a friend too fast on a water ski and crashed into a dock, seriously injuring the skier. Although hypothetically the defendant may argue that the accident was caused by a boat malfunction, it’s easy to see that holding the boat in an LLC won’t exculpate the client from liability.
A final planning suggestion is that, if any of the assets are used in the business (building or equipment), the LLC owning the asset(s) should lease it to the business so that rental income can be created (which is better than earned income from a tax perspective).
Contributor: Thomas E. Greene III | Aug 23, 2017
See Thomas E. Greene III, “Well-Crafted Self-Settled Trusts Formed by Nonresident Settlors Will Withstand Legal Challenge,” LISI Asset Protection Newsletter #328 (August 2016), at www. leimbergservices.com.
See, e.g., Walker v. W. Mich. Nat’l Bank & Trust, 324 F. Supp. 2d 529, 534 n. 3 (D. Del. 2004), aff’d., 145 Fed. Appx. 718 (3rd Cir. 2005).
For additional information please contact us for free consultation.
As a reminder, this Blog Post is for informational purposes only and is not intended as legal or tax advice.