Analysis by Mark Lobb
Asset Protection: Offshore and Domestic Trust Analysis
The exotic sounding foreign asset protection trust aka offshore trust continues to be heavily marketed by promoters. Jurisdictions such as Barbados, British Virgin Islands, Cayman Islands and Cook Islands are just a few of the asset protection or tax havens embraced by promoters. I have had several clients recently tell me they have been contacted by offshore trust promoters, so I thought it was a good time to address the implementation of an offshore trust structure.
There are times when an offshore trust structure is useful. Those instances of utility are rare for a U.S. citizen holding U.S. tangible assets. The benefit of an offshore trust structure increases for those who have dual citizenship or for U.S. citizens holding intangible assets and have no claims against them at the time the structure is put in place. Domestic trusts properly planned and drafted provide as much or more asset protection than offshore trusts for U.S. citizens. Furthermore, domestic trusts are easier to manage, cheaper to maintain and merge seamlessly into an individual’s estate, tax, and succession plans.
The case for offshore trusts for a U.S. citizen is premised upon the idea that if assets are in a jurisdiction outside of the U.S. that favors debtors, the assets are protected. An offshore trust can be helpful to protect intangible assets held by a person who creates and funds the trust with intangible assets before a claim arises. However, the same can be said for a domestic trust. Promoters of foreign trusts often claim no trust in their jurisdiction has ever been penetrated by a judgment creditor. This claim misses the point. The laws of the U.S. will control the asset protection benefits of the offshore structure holding the debtor’s assets and deal with the U.S. debtor under U.S. laws. As discussed below, the assets may be stowed away and controlled by someone other than the debtor in the Cook Islands, but the debtor may be sitting in jail in the U.S. as a result.
The most effective outcome in using an offshore trust to protect a debtor’s assets after a claim arises concerns the complications created by its existence. The complication may cause the creditor to walk away from a valid claim or significantly compromise the claim to avoid uncertainty and cost. However, there is a cost and uncertainty absorbed by the debtor in creating and maintaining the offshore structure. The cost and uncertainty held by the debtor in having assets in a foreign trust are substantially more than having those assets in a domestic trust.
Furthermore, a measured plan for a wealthy person integrates asset protection, estate planning, and tax optimization. Offshore planning is focused heavily on tax fraud or asset protection. Estate planning, tax optimization, and succession planning seem to be intentionally ignored or negligently abandoned. People who implement offshore structures often do so hastily because they have an angry creditor coming after them, or they are trying to hide assets from a divorcing spouse or bankruptcy trustee. Additionally, there are numerous tax fraud schemes employed through offshore trust structures. Tax fraud motivation or rushed asset protection structures do not adequately address estate planning and succession needs. Domestic trusts provide substantially more flexibility for the U.S. citizen with U.S. assets in successfully putting in place an integrated structure.
For the past 30 years, United States courts have not allowed offshore trusts to frustrate the rights of creditors. Consistently courts have taken the following steps to break through the paper of offshore trust planning:
- Courts have incarcerated debtors for playing games with assets held in offshore trusts to the detriment of creditors,
- Courts have included assets in offshore trusts in domestic bankruptcy estates, and
- Courts have 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 167 times with no negative subsequent appellate history on the issues as they relate to this article.
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.
Domestic asset protection trusts are currently recognized in 17 states: Nevada, Alaska, Delaware, Hawaii, Michigan, Mississippi, Missouri, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming. Of those 17 states, Nevada, Alaska and Wyoming currently have the most 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 viable fraudulent conveyance claim disappears. The trust structure 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 specific planning 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. Lobb & Plewe, LLP has created a proprietary asset protection trust structure called “The Passage Trust.” Information relating to that trust can be found at www.passagetrust.com.