Domestic v. Foreign Jurisdiction Issues and Analysis
There is a surge in promoters selling foreign asset protection trusts, otherwise referred to as offshore trusts, to wealthy U.S. citizens and business owners. There are times when offshore trusts are useful but those instances are rare for a U.S. citizen. The utility in using offshore trusts increases for those who have dual citizenship. Domestic trusts properly planned and drafted provide more asset protection than offshore trusts for U.S. citizens. Furthermore, domestic trusts are easier to manage, cheaper to manage and merge seamlessly into an individual’s estate, tax and succession plans.
The case for offshore trusts is premised upon the idea that if the assets are in a jurisdiction outside of the U.S. that favors debtors, the assets are protected. This proposition is not always true and ignores some very negative consequences to sheltering assets offshore. The best that can be said for offshore trusts if they are being used solely for asset protection purposes is that you make a creditor’s life complicated. The complication means they may walk away from a valid claim or significantly compromise their claim to avoid uncertainty and cost. However, there is a cost and uncertainty absorbed by the debtor in creating and maintaining the offshore structure.
A measured plan for a wealthy person integrates asset protection, estate planning, and tax optimization. A wealthy business owner needs to add succession planning into the mix. Offshore planning is focused heavily on asset protection. Estate planning, tax optimization, and succession planning seem to be intentionally ignored or negligently abandoned when implementing an offshore trust structure. Usually, people who use offshore structures do so hastily because they did not plan in advance and have a monster of a creditor coming after them or they are trying to hide assets from a divorcing spouse or a bankruptcy trustee. Additionally, there have been numerous tax fraud schemes employed through offshore trust structures as well.
The majority of offshore trusts are pushed by promoters selling cookie-cutter structures. The client is either a debtor who is panicking because creditors are at the door and the client is willing to do anything not to satisfy a claim, or the client simply fails to understand a better choice lies in using a properly structured domestic trust.
For the past 25 years, courts in the United States have not allowed offshore trusts to frustrate the rights of creditors. Consistently courts have incarcerated debtors for playing games with assets held in offshore trusts to the detriment of creditors, included assets in offshore trusts in domestic bankruptcy estates, held transfers to offshore trusts as fraudulent conveyances, and ignored the existence of the offshore trusts for purposes of determining ownership of assets in the United States.
Incarcerations take two forms. The first example of incarceration is when a debtor is jailed for an unspecified term pending the offshore assets being repatriated to the United States to satisfy a creditor. The other form of incarceration is when the term consists of a specific jail sentence based upon a conviction of fraud. A classic example of the fraud conviction is reflected in SEC v. Brennan (2000) 230 F.3d 65. The Brennan case is mentioned here because it has lasted the test of time. As of the date of this article, it has been cited by other courts 114 times with no negative subsequent appellate history.
In addition to U.S. courts not embracing offshore trusts, once you have created such a trust or you are a beneficiary of an offshore trust, there are extensive filing requirements with the IRS.
If you are the U.S. person who creates the offshore trust you are the ” Grantor” or ” Settlor” of the trust. Obviously it is imperative you consult with your CPA but be mindful that your reporting responsibilities begin with checking the box on IRS Form 1040, Schedule B, Part III and then filing (1) IRS Form 3520, (2) IRS Form 8938; and (3) FinCEN Form 114 (commonly referred to as the “FBAR”). The trustee in the offshore jurisdiction is required to file IRS Form 3520-A. If the trustee fails to file this form, then the person who established the trust is required to do so.
If you are a beneficiary of an offshore trust, and you receive a distribution from the foreign trust, then your reporting responsibilities are the same as the responsibilities of the Grantor which are mentioned above. Again, you need to check the box on IRS Form 1040, Schedule B, Part III and file IRS Forms 3520 and 8938. If you receive more than 50% of trust income or assets, you must also file FinCEN Form 114 (the FBAR).
The forms mentioned above notify the U.S. Government that you are transacting with an offshore trust, and you are required to disclose certain offshore account information. The FBAR is electronically submitted on the Financial Crimes Enforcement Network website which is a division of the United States Treasury Department.
Finally, most offshore trust structures require you have an independent trustee. That trustee will have control of your assets. What happens if that trustee disappears? What happens if there is a coup in the jurisdiction of your trust? What happens if the trust company is taken over by the government and the assets are frozen or worse yet liquidated? What happens with the assets in the trust if the trust company goes into bankruptcy? To answer the last question you will need to learn the bankruptcy laws in the jurisdiction of your offshore trust. What happens if you seek a distribution and the trust company says “no”? If denied a distribution, will you need to sue the trust company in the offshore jurisdiction?
With a properly drafted and funded domestic asset protection trust, you receive substantial asset protection without the complexity of having to deal with offshore trustees and lawyers. Furthermore, you do not have any of the filing requirements necessary for offshore trusts. Importantly, the courts will not have the perception of a fraudulent conveyance if you dutifully follow the laws of the jurisdiction of the trust. The “perception” of something being inappropriate is actually discussed in some of the court opinions regarding offshore trusts.
In California, courts have upheld the asset protection qualities of a properly drafted trust. For instance, in Young v. McCoy the creditor attempted to satisfy a judgment through the assets held in an asset protection trust. The creditor sued the trustee of the trust to compel a distribution. The debtor was in jail for the attempted murder of the creditor. The court held the trust did not have to make a distribution from the trust to satisfy the creditor because the trust indicated the distributions were discretionary with the trustee. The trustee did not feel a distribution was necessary because the beneficiary/debtor was getting three meals a day and had a place to sleep thanks to the hospitality of the California prison system.
If you are a California Resident and own California real estate it is a great idea to own the real estate in an LLC owned by an irrevocable grantor trust. If you hold assets out of California, it is wise to keep those assets in a trust structure outside of California. There are instances whereby a California resident will benefit by employing the jurisdiction of another state for their asset protection trust, but this analysis is heavily dependent upon the residency plans of the person seeking the asset protection, the assets to be held, and the protection sought. There are approximately 15 states which claim to have enhanced asset protection laws for trusts. There are laws in those states which create certain advantages but those advantages require certain fact patterns to exist in order to realize any benefit. Of those 15 states, Nevada seems to have the edge when it comes to asset protection trusts but Alaska and a few others have very attractive planning options.
The key to making an asset protection trust work properly is to plan it in advance of having a creditor come after you and your assets. As the trust ages, any potential claims of fraudulent conveyance begin to disappear and the trust becomes stronger and stronger over time.
If you are a U.S. citizen with dual citizenship you may find advantages to keeping your offshore assets in a non-U.S. jurisdiction but that analysis is subject to your needs. Ultimately, the use of an offshore trust for a U.S. citizen is not a better planning tool than a domestic asset protection trust and the offshore trust will cost more to create and maintain.