- Estate Planning Integration
- Legal Threats
- Family Limited Partnerships
- Foreign Asset Protection Trust
- U.S. Income Tax
- U.S. Estate & Gift Tax
- Domestic Asset Protection Trust
Asset Protection Definition
Asset Protection planning is the process of utilizing planning techniques available to preserve and protect accumulations of wealth from the multitude of potential claims arising from future litigation, government expropriation and other threats. This can involve a wide variety of situations and many different areas of law. The key questions to ask are: What potential sources of liability are you exposed to that indicate use of asset protection strategies? Who are the potential plaintiffs that might initiate litigation and ultimately seize your assets? The term “creditor” is used in this outline to refer to anyone that might initiate litigation and obtain a judgment against you.
“FAPT” refers to a Foreign Asset Protection Trust (FAPT) which is also known as an Offshore Trust. “APT” more generally refers to an Asset Protection Trust which could be based upon the law of a foreign country or the state law of a state of the United States.
Asset protection planning is not based on hiding assets or secrecy. Although the confidentiality respected by the offshore centers is appreciated by most clients, it will not make any difference in the ultimate protection of assets. If you appear in Court or are legally required to disclose your financial information in any context, your failure to disclose a FAPT or other asset will be fraudulent, a violation of law and possibly a criminal violation.
Asset protection planning is not a means to evade or avoid taxation in the United States. This is not possible under the U. S. income, estate and gift tax laws as discussed later in this outline.
Asset protection planning is not a means or any part of making a fraudulent conveyance. If a Court judgment has been entered, a lawsuit has been filed, or even threatened, it is generally too late to do asset protection planning.
Why should asset protection planning be part of your traditional estate planning? Estate planning focuses on what happens when you pass away. Your Will or Trust designates who will receive your estate and upon what terms. However, what will happen if you are sued and a Court judgment is entered against you for a sum of money large enough to consume your whole estate? The creditor may collect and there will be no estate when you pass away. More importantly, there may be no estate when you are ready to retire. Thus, asset protection planning should be part of everyone’s estate planning and, for business owners, part of their business planning.
Legal Threats to Your Assets
Ninety four percent of all lawsuits in the world are filed in the United States. Seventy percent of the world’s lawyers reside in the U.S. In a one year period there were 40,000 product liability lawsuits in the U.S. and only 200 in the U K. The U.S. has thirty times more lawsuits per person than Japan. The U.S. leads the world in the costs of litigation. Lawsuits consume 2.2% of GNP.
- Contract Creditor, Debt or Guarantee
A normal consumer debt or a bank loan could result in a claim against your assets. If you guarantee or sign on a loan for another person, you could end up paying for the loan in full.
- Partnership Obligations
A partner or business associate can create liabilities or expose you to a lawsuit. In general, a partner is legally responsible for all acts of the other partners even if they were not at fault.
- Business Owners
Business owners are exposed to lawsuits from a variety of sources depending on the nature of the business. In recent years, employee lawsuits for wrongful discharge, discrimination, sexual harassment, Americans with Disabilities Act and the Family & Medical Leave Act have resulted in large verdicts against employers.
- Corporation Unlimited Liability
The general rule is that the corporate structure limits the liability of the shareholder to losing only their investment in the corporation and they are not personally liable for any corporate debts or judgments. However, under the pierce the corporate veil legal theory, the shareholders can be held personally liable and plaintiff s attorneys have had success in utilizing this legal argument. This legal theory was not part of the very first corporate laws passed by the legislature but was created by court decisions over the years.
- Officer’s & Director’s Liability
A corporate officer or director can be held to be personally liable for the corporation’s liabilities in spite of the limited liability feature of the corporation. Officers and directors of corporations can also be personally liable under numerous provisions of securities laws, tax and other regulatory laws for their acts associated with corporate activities. Many such officers and directors of failed financial institutions have been held to be personally liable for bad loans or real estate development investments.
- Tort Lawsuit
The United States is the world’s most litigious country. Incidents ranging from car accidents, accidents at your home by a guest, to spilled hot coffee can form the basis for a multi-million dollar lawsuit against you. For more examples of lawsuits, go to the following websites: American Tort Reform Association (www.atra.org) and California Citizens Against Lawsuit Abuse (www.cala.com).
Tort Reform Legislation: There have been bills introduced in Congress to enact tort reform measures such as limits on non-economic damages, caps on punitive damages etc.. in medical malpractice cases and tort cases in general. Ohio has enacted medical malpractice reform with the following provisions:
• Limits damage awards for noneconomic loss to the greater of a) $250,000, b) or 3 times economic loss but not to exceed $350,000 per plaintiff or $500,000 per occurrence.
• However, the maximum limits for noneconomic loss from permanent disability or deformity are $500,000 per plaintiff or $1,000,000 per occurrence.
• There is no limitation on economic loss awards.
The above limitations do not apply to a wrongful death action.
Ohio House Bill 215 enacted 9/13/04 sets forth new requirements for the filing of a medical malpractice action as follows: a) Certificate of review by a medical expert prior to filing an action; b) Qualifications for expert witnesses; c) Affidavit of Noninvolvement for defendants who should not be included in the lawsuit; d) Expedited discovery; e) Inadmissibility of “I’m sorry” statements by physicians.
Such legislation is generally a positive development from an asset protection point of view. However, these laws have yet to be tested in the Courts and some judges tend to dislike the idea of injured persons being left without a remedy in the court system. Judicially created exceptions to this type of law are not unprecedented. The new laws have their own exceptions to the general rules limiting damages or liability. If a particular plaintiff can fit within one of the exceptions, then you are exposed to unlimited liability. Unless specifically provided for in the tort reform law, such new laws will not necessarily result in lower medical malpractice or liability insurance premiums. It will be up to the insurance industry to voluntarily lower their premiums after such legislation.
- Environmental Laws
Anyone owning real estate could be charged with the responsibility of environmental clean-up costs for any violation of the environmental laws. This is true even if you are not the present owner or if you purchased with no knowledge of any problems. Prior owners of real estate can be held legally responsible by virtue of their ownership without any fault in creating the problem. Thus, you could be held liable in a court judgment or administrative action for real estate that you sold a long time ago. Directors and officers of corporations have been held to be personally liable on the grounds that they had substantial control over the land.
- Liability Insurance Non-Coverage
Liability insurance that appears to promise coverage for some type of liability often provides only a limited coverage or is negated by the numerous exceptions buried in the policy. Some insurance companies are known for a practice of denying coverage or payment of claims. Reading one of your malpractice, umbrella or other liability policies can be an enlightening exercise revealing a large number of situations for which you have no coverage. A common exception that resulted in large jury verdicts against real estate owners was liability for asbestos related injuries. The insurer could also file for bankruptcy and go out of business.
- Divorce Court
A divorce proceeding can of course have a dramatic effect on anyone’s estate. A premarital agreement done prior to the marriage can effectively protect ones premarital estate in the event of a subsequent divorce. However, premarital agreements have often not been enforced by the Courts and alternate legal theories have been advanced to allow recovery by a divorcing spouse. Similar concerns can arise in the context of an estate plan to protect the inheritance of the children in the event of their marital problems.
- Nursing Home Costs
If you should need nursing home care, this will cost $80,000 to $120,000 per year and will not be covered by Medicare or supplemental insurance. The best planning option is to obtain long term care insurance coverage. Legal planning for Medicaid eligibility can also protect a person’s estate from nursing home costs. These materials do not cover this topic which is the subject of a separate outline and seminar presentation.
- Economic Concerns
The United States economy is burdened by a staggering deficit, financially unsound Social Security and Medicare programs, interest on the federal debt and government spending. Foreign markets and currencies may provide a more stable investment vehicle and the opportunity for diversification not available in domestic markets or with mutual funds.
The purpose of the above is to alert the reader to some of the potential exposures to legal liability that could result in a loss of your estate. All possible lawsuits or potential liabilities can not possibly be explored or predicted in these materials. Each person must assess their potential exposures to liability based upon their activities, profession, business, ownership of assets or other circumstances. You must weigh these potential liabilities against your aversion to risk and consider to what extent you will engage in asset protection planning.
Family Limited Partnerships
Family Limited Partnerships (FLP’s) became a popular estate planning tool during the 90’s. It is now one of the most popular estate & asset protection planning strategies. An FLP is simply a partnership used to hold a family business or all assets or investments of the family estate. An FLP is not just for persons who own a business. Investments can be the sole assets of an FLP. However, you cannot transfer a personal residence to a FLP for estate & asset protection planning. Such personal assets held in a FLP would result in adverse income tax consequences. Thus, a FLP is used in a manner similar to a trust to achieve estate & asset protection planning objectives. The family members, mom, dad, children or other heirs, are the partners. Through use of tax-free gifts and valuation discounts to the FLP the estate and gift tax burden can be greatly reduced.
- Partnership Law
In a general partnership all partners are liable for the debts of the partnership and actions of the other partners. This is not a common investment vehicle due to the unlimited liability exposure of the partners. A limited partnership consists of at least one general partner and other limited partners. The limited partners are not personally liable for the debts or other liabilities of the partnership. The most that they can lose is their investment in the partnership. The general partner is liable for partnership debts. It is possible for the general partner to be a corporation or LLC but this entity must be adequately capitalized.
Typically, an FLP is formed with the parents as general partners and also owning limited partnership shares. The parents usually contribute an amount equal to or greater than the estate tax exclusion amount net of valuation discounts to the FLP. The parents still retain control over all the assets of the FLP since they are the general partners. The general partner has power to make all investment and management decisions over the assets and can continue to receive income from the assets by being paid a salary for management of the FLP. For gift and estate tax purposes a transfer has been made to the children and, thus, the estate is reduced. This combination of benefits is difficult to achieve by use of trusts or other estate planning methods. The FLP also restricts the limited partners from selling their shares so that they cannot use the assets for their own personal expenditures.
- Estate/Gift Tax Savings
A gift of a business interest or investment assets to an FLP is also subject to valuation discounts. In other words, since the limited partner (child or other heir) does not have management control of the assets in the FLP, his/her share of the FLP is worth less than the pro rata amount. In accordance with established tax valuation principles, there would be a discount from this pro rata value. For example, if the child’s percentage ownership was 40% of $1,000,000 ($400,000), for gift tax purposes the transfer may be discounted to a value of $280,000. Thus, you can transfer property worth $400,000 but, for gift tax purposes, you are considered to have transferred only $280,000. The FLP agreement also restricts limited partners from selling their limited partnership shares. This restriction reduces the marketability of the shares and thus, provides a further basis for a discount from the full pro rata value. The FLP also offers the benefit of avoiding estate tax on appreciation of the assets after the transfer to the FLP. For example, a person could transfer real estate worth the estate exclusion amount (presently $5,000,000). There would be no gift tax due but the person’s lifetime gift tax exclusion would be used up. If the real estate is worth $5,300,000 on the date of the person’s death years later, then $300,000 will have avoided estate tax. The real estate in the FLP is not subject to the estate tax since a completed gift was previously made by the person.
- IRS Position
The IRS initially tried to fight the onslaught of FLP’s in the 90’s. In 1997, the IRS issued some rulings disallowing the use of FLP’s for taxpayers. This received a lot of publicity and even in the legal and tax communities intimidated some estate planning professionals from using this planning tool. However, there are solid legal grounds for utilization of the FLP and in the last few years there have been numerous significant victories in Court by taxpayers. Estate planning attorneys and FLP appraisers across the country are reporting significant discounts and estate tax savings in these last few years. The IRS has been beaten in Court and is more willing to settle cases upon appeal.
- Sam Walton
An interesting example of the FLP planning technique is found in the estate of Sam Walton. The Waltons started the Walton’s Five and Dime in the early 1950’s and built an immensely successful chain of discount retail stores. At the time of Sam Walton’s death in April of 1992, he owned a 10% share in the family partnership Walton Enterprises. Very early on in the life of his business, he created the partnership with he, his wife, and all his children as general partners. His primary source of income was his compensation as manager of Walton Enterprises. Note that his transfer of the shares of the business was made near the inception of the business when their was little or no gift tax incurred. The business appreciated and the children still owned their shares without paying any estate tax upon Sam’s death. The key to this tax savings was an early transfer before appreciation. Sam did not retain the control he could have since all of the family were general partners. He could have made them limited partners. When Sam Walton passed away, his 10% share passed to a marital trust for his wife, thus qualifying for a marital deduction on the estate tax return and no tax was due. When his wife passes away, her 10 % and Sam’s 10% will pass to a family charity qualifying for a charitable deduction and, thus, no estate tax will be due. It has been estimated that the Walton fortune was worth $20 to $25 billion dollars. This same planning technique can be used for persons who do not have a family business. Persons owning only stocks, bonds or other securities can use an FLP to dramatically reduce their estate taxes. It is important to realize that there is no free lunch in this type of estate planning. The estate/gift tax laws are designed to tax all property whether it transferred by gift or at death. Thus, any gift transfer of an FLP limited partnership interest over the federal gift tax exclusion amount will use up the estate exclusion amount or be subject to gift tax when cumulative lifetime gifts exceed the gift tax exclusion amount. The key planning advantage is to transfer early and avoid estate tax on appreciation and to save tax by qualifying for minority or marketability discounts. The distinguishing advantage over an outright gift is that the parents can retain control over the assets and still receive the income.
- Asset Protection
If the general partner or limited partners are sued by outside creditors, they cannot seize or force a sale of the underlying assets of the FLP. Remember that once you set-up a FLP you do not own the assets. Technically, the FLP owns the assets. Of course, you control the FLP and manage the assets. An outside creditor can only seize assets legally titled in your name. The partnership shares are in your name but partnership law generally limits a creditor to a “charging order” against the partner. This order gives the creditor the right to receive any distributions of income that may be made to the partners. The creditor cannot force a distribution and the general partner has full authority to decide to make no distributions. However, the creditor will receive a form K-1 and, thus, will probably have to report this taxable income on its income tax return.
The effect of this charging order provision is that a creditor will probably receive nothing for its efforts and this will discourage any enforcement action by creditors.
There have been a few cases in other States (Mississippi) allowing an actual forced sale of a limited partnership interest and some States (California) have changed their statute to allow for a foreclosure on the partnership interest. There is a growing concern among practitioners that the Courts are changing their remedies to allow more than a charging order. Some Courts have actually allowed a foreclosure on the Partnership interest. However, even if a foreclosure is allowed, the result is that the creditor now owns the FLP interest as an assignee. An assignee does not have the rights of a partner such as a right to vote on partnership decisions, right to examine partnership books and records etc.. Although the assignee creditor could sell its interest, the sale would likely be at a substantial discounted price (if a buyer could even be found) due to the lack of control and liquidity of such an assignee interest.
The person who is forming a FLP for asset protection purposes should consider forming the partnership under the laws of a State with more favorable protection on the issue of the charging order. There are a few States that provide specifically by statute in their partnership law that a charging order is the sole remedy of a creditor and, thus, the creditor cannot foreclosure on the partnership interest. These States are: Ohio, Alaska, Arizona, Delaware, Nevada and Oklahoma.
Limited Liability Co. (LLC)
In most States, a LLC cannot be used in this same manner as an FLP since creditors and the LLC member under a LLC statute can force a liquidation. The member also has a right to force a sale of his/her interest and receive fair value which would greatly reduce valuation discounts and, thus, reduce estate/gift tax savings. However, the Ohio LLC statute has eliminated these provisions and a LLC can be used in Ohio in the same manner as a FLP. In general, in Ohio there is no advantage to using a FLP rather than an LLC in most circumstances. But note that a sole member LLC should not be used for asset protection due to the pierce the corporate veil theory which could allow creditors to reach personal assets of the LLC owner.
Foreign Asset Protection Trust (FAPT)
A Foreign Asset Protection Trust (FAPT), also known as an Offshore Trust, is a trust created under the trust laws of a foreign country and administered by a trustee located in an offshore financial center (OFC). A FAPT is not really that exotic or different from the more common trusts used in the United States. The drafting of a FAPT is very similar to domestic trusts.The common law trust principles applicable to domestic trusts also form the basis for a foreign asset protection trust. The professionals in these OFC generally speak, write and use English. It is estimated that there are $5 trillion of offshore funds in the 61 tax havens of the world. Approximately, $2 trillion is held in foreign trusts and one-half of this is in trusts used as an Asset Protection Trust. This $5 trillion figure is increasing at an estimated $100 billion annually. Since the tax changes in 1976, FAPT declined in popularity. However, beginning in the 1990’s, with the tremendous flood of litigation in the United States arising from malpractice, securities law violations and negligence, savings and loan frauds, and divorces, legal advisors and their clients renewed their interest in FAPT. In this area of practice, it is very important for the advisor to undertake a due diligence investigation of his/her potential client. This is not commonly done in the United States by most legal, financial and tax advisors. In international banking circles this is a common and required practice. It is also very important to educate the client about all the required U.S. tax reporting requirements and to emphasize the fact that income from all offshore trusts is taxable income to them. Virtually all responsible estate and asset protection planners go to great lengths to explain to clients that most such plans are tax neutral and that offshore trusts are subject to extensive reporting requirements to the IRS. Money laundering and tax evasion are not what asset protection is about. Gone are the days when an individual could walk into a Swiss (or any other) bank with an attache case full of cash, be warmly received, and open a private account. Today, such an individual would be lucky if he or she were simply turned away, instead of being reported to the authorities for suspicion of money laundering.
- Motivations For Establishing a FAPTThere are generally two reasons that clients use offshore trusts: 1) asset protection; 2) and meaningful economic diversification. Generally speaking, a portfolio of at least $1 million is required in order to initiate a FAPT. There are many other non-asset protection motivations that might or should form the basis for going offshore such as the following:
- Economic diversification: There are many investment opportunities available in the international marketplace that are not available in the United States because of burdensome SEC requirements and restrictions. It is estimated that 53% of the world’s market capitalization resides outside the U.S. The sophisticated international banks operating in these offshore financial centers (OFC) provide access to these opportunities.
- The achievement of a low-profile or anonymity with respect to wealth: OFC provide by law that disclosure of any trust information to a foreign government (i.e., United States) or any other organization or person is prohibited. Thus, you can expect greater privacy of your affairs than with a U.S. trust.
- The avoidance of forced dispositions: Most state’s laws provide for some type of requirement that a surviving spouse is entitled to inherit a certain percentage of the deceased spouse’s estate regardless of the provisions of a Will or Trust. Some European countries provide similar inheritance rights to children. In Ohio, a surviving spouse is entitled to a certain percentage (one third to one half) of the probate estate. However, in Ohio use of a funded revocable living trust can avoid a spousal claim against the estate since such claim is only against the probate estate and not trust property. There have been bills introduced in the Ohio legislature to expand the spousal claim to cover trust property and all other non-probate property.
- Premarital planning: Premarital agreements have often not been enforced by the Courts and alternate legal theories have been advanced to allow recovery by a divorcing spouse. Use of a FAPT can assure the intended disposition of the estate in the event of marital problems.
- Estate tax planning (e.g., establishing a vehicle for exemption equivalent trusts and generation skipping transfer tax exemption trusts) : a FAPT can be used in the same manner as other trusts to reduce U.S. federal estate and gift tax.
- Planning for the contingency of changing one’s domicile or citizenship.
- Securing offshore private placement life insurance.
- Preplanning in anticipation of currency controls or restrictions on ownership of bullion.
- Liability protection, tax planning, or strategic advantage in the context of an active trade or business abroad.
A FAPT does not provide any exemption or savings from U.S. income, estate or gift taxes. Income you receive from the FAPT is subject to U.S. income tax. Do not be misled by promises of secrecy of the FAPT. There are U.S. tax reporting requirements and other procedures designed to ensure reporting of income. There have been successful criminal prosecutions by the IRS of persons who did not report income from a FAPT.
- Why Your Assets Are Safe from Creditors
An offshore country by its laws does not recognize the validity of a judgment obtained against you in a U.S. Court. This is called a lack of comity. Therefore, a creditor would have to initiate a new lawsuit in the foreign country. Also, the creditor may be required to use an attorney in the foreign country, thus, increasing their cost of pursuing the case.
- Statute of Limitations
Laws often require that any lawsuit be brought within a short time (e.g. two years) after the cause of action occurs. After this time, the lawsuit related to that event is prohibited. Some countries also require the plaintiff to post a bond and pay the defendant’s legal cost if the plaintiff is not successful.
- Flight Clause
The trustee also has the power to move the location of the trust to another country in the event of a lawsuit.
- Exception: Fraudulent Transfer
As with U.S. law, the law in the OFC prohibits fraudulent transfers. These OFC do not want assets from someone attempting to evade existing creditors. Thus, you need to create a FAPT before any financial problems.
The 61 OFC vary greatly in the specifics of their laws and how they provide asset protection. A detailed legal analysis of each of these countries is required before deciding which is best to achieve your objectives.
- But Are YOU Safe from Your Creditors?
- Personal Jurisdiction
If you create an FAPT, remember that if you are still a U. S. citizen and live in the U. S., you are subject to the jurisdiction of U. S. Courts. A Court could order you to repatriate your assets or take other actions to obtain your FAPT assets to pay a creditor. Your failure to comply with the Court’s order could cause you to be in contempt of court and you could be sentenced to serve time in jail. However, if your FAPT has been properly drafted and planned, you will not have this problem. You should not have any legal right to demand anything from your FAPT and, thus, the Court could not order you to repatriate these assets. If such an order was issued, your legal defense would be the doctrine of impossibility of performance. This is a well established legal defense based upon years of precedent.
- Possible Creditor Remedies
A strongly motivated creditor can pursue legal action in a foreign country. However, there will be substantial cost and delays in such a process.
A bankruptcy trustee may deny the bankruptcy discharge in the bankruptcy proceedings based on the existence of a foreign asset protection trust. The bankruptcy trustee also has the power to avoid a fraudulent transfer within one year prior to the filing of the bankruptcy. In addition, the bankruptcy trustee can also utilize state fraudulent transfer laws.
A creditor pursuing legal action will attempt to obtain records from the offshore trustee or other fiduciaries. They will attempt to obtain any and all files which might contain letters from the grantor or other U.S. persons. Any correspondence to a foreign trustee should keep in mind the possibility of eventual disclosure. If the foreign trustee has any U.S. contacts this will subject the trustee to the jurisdiction of the U.S. court. For example, there was a case in which a subpoena was served on the Bank of Nova Scotia’s Miami, Florida offices demanding documents held at its Bahamas, Cayman Islands and Antigua branches. The Bank of Nova Scotia failed to comply and was held to be in civil contempt with a fine of $120 million. On appeal, the finding of contempt and the penalty were upheld.
The creditor can also seek to hold the U.S. person in civil contempt for failing to comply with the court order to consent to release of records by foreign fiduciary. However, a valid defense for the U.S. person is that it is impossible for them to comply with the order. This is the doctrine of impossibility of performance. If the U.S. person has made all reasonable efforts to comply with the court order, he/she cannot be held in contempt.
The Hague Convention also allows discovery outside of the United States. The procedure is for a letter to be issued by a U.S. court to a foreign court asking for the discovery order. As a general principle, the court receiving such a request is required to comply. However there are many exceptions to this which are often utilized by the foreign courts. In the context of a U.S. court action, the court may choose between using U.S. discovery rules or the Hague convention procedure. Some of the exceptions and limitations of the Hague convention are as follows: 1) It can only be used in a civil or commercial proceeding; 2) Foreign courts do not allow fishing expeditions for evidence; 3) Professional privilege may protect discovery.
- Personal Jurisdiction
U. S. Income Tax
The income of the FAPT is taxable income to the Settlor. This is true even if the income is not actually distributed to the Settlor or beneficiaries. Note the two questions on Form 1040, Schedule B, items 7 & 8, of your income tax return. This is the schedule listing your interest and dividend income. See Appendix.Prior to the Tax Reform Act of 1976, the tax rule was different and income generated outside the United State by assets of a foreign trust was free of U.S. income tax. This former rule may be responsible for the common misunderstanding that an FAPT is tax-free.However, a Pecuniary Dynastic Offshore Trust (PDOT) can achieve an extraordinary income tax savings because the PDOT can grow free of all U.S. income tax after the death of the grantor. After the grantor’s death, the trust will not be subject to U.S. tax except on its U.S. source income. However, distributions to U.S. beneficiaries may be taxed in the hands of the beneficiary. This can be avoided by providing in the trust for a distribution of a specific sum of money payable in not more than three installments. The amount of this distribution should not be included in the beneficiaries income under 662(a) of the Internal Revenue Code.
- U.S. Income Tax Reporting RequirementsThere are numerous reporting requirements every year for a trust that is classified as a foreign trust. The assistance of U.S. counsel is very important for the compliance with U.S. tax laws. The foreign trustee does not have the expertise to meet these requirements and relies on (in fact, usually insists on) the Settlor’s use of U.S. counsel.
- Grantor Trust
The grantor trust income tax rules require that certain trusts are treated as owned by the grantor with the result that the grantor must include all trust income in his/her personal income tax return (form 1040). I.R.C. 679 provides that any United States person who transfers property to a foreign trust that has a U.S. beneficiary is automatically a grantor trust. The trust is treated as having a U.S. beneficiary if under the terms of the trust some part of the income or principal may be paid or accumulated for the benefit of a U.S. person and, if the trust were terminated, some part of the trust could be paid for the benefit of a U.S. person. Even if the FAPT is not a foreign trust, it will most likely still be a grantor trust since the settlor will be a discretionary income beneficiary and may have retained a “special power of appointment.”
- Foreign Trust Definition
All Trusts are foreign trusts unless: 1) A U.S. Court is able to exercise primary jurisdiction over the trust and, 2) one U.S. person has authority to control all substantial decisions of the trust.
The first requirement may be met by adding a clause giving a U.S. Court jurisdiction over the trust but allowing the foreign trustee discretion to change the jurisdiction to the OFC. The second requirement may be by appointing a U.S. trustee as co-trustee or protector or allowing the grantor to be protector. If a crisis develops, then the U.S. Trustee is removed and the grantor/protector resigns their office. Thus, a properly drafted FAPT could possibly be classified as a “domestic trust” for tax purposes, thus, simplifying income tax reporting.
- Taxable Gain on Transfer
The transfer of property by a United States person to a foreign trust is treated as the sale or exchange resulting in taxable gain. However, this rule does not apply if the trust is treated as a grantor trust.
- Double Taxation
The potential for double taxation of income by the United States and the foreign country is generally remedied by unilateral tax credits and bilateral tax treaties.
- U.S. Income Tax Forms
- FAPT as Domestic Trust
Form 1041 or statement; see Treas Reg. 1.671.4; Treas Reg 301.6109.1 re tax IDThe “import the law” plan attempts to qualify as a domestic trust and, thus, would only need to file form 1041.
- FAPT as Foreign Trust
Form 3520: Annual Return to Report Transactions with Foreign Trusts … ; penalty for failure to file of 35% of value of trust assets Form 3520A: Annual Information Return of Foreign Trust with U.S. Owner; penalty for failure to file of 5% of value of trust assets TD (Dept. of Treasury) form 90-22.1: Report of Foreign Bank and Financial AccountsThe “export the assets” plan will be a foreign trust and, thus, the grantor will need to file the above forms related to a foreign trust.
- FAPT as Domestic Trust
- Other Forms
- IRS Form 8300: person who receives more than $10,000 cash in the course of a trade or business; cash means U.S. and foreign coin or currency; penalty for failure to file: $25,000 minimum; 5 years imprisonment or fines up to $250,000;
- TD Form 4790: person who physically transports, mails or ships currency or other monetary instruments in aggregate amount exceeding $10,000 into or out of the U.S.; exception for a transfer of funds through normal banking procedures not involving physical transportation; penalty is a fine not more than $500,000 and imprisonment not more than 10 years
- IRS Form 4789: financial institution must file for deposit, withdrawal, or other transfer in currency of more than $10,000; financial institutions includes banks, securities broker/dealers
- Suspicious Activities Report: financial institution must file for any known or suspected criminal violation, potential money laundering, etc..
- Grantor Trust
U. S. Estate and Gift Tax
The FAPT can be structured so that you have not made a gift subject to gift tax and, thus, upon your death the trust assets are subject to U.S. estate tax. Conversely, it may be advisable to make a taxable gift to the trust and, thus, there would be no estate tax on the trust assets. A typical FAPT does not involve a gift tax. This is accomplished by giving the grantor a “special power of appointment” to change the beneficiaries of the trust. Thus, there is generally no estate or gift tax advantage to a FAPT.
Domestic Asset Protection Trusts
Some States have enacted statutes that change the common law rule of trusts that permit a self settled trust to protect the settlor’s assets from creditors of the settlor. These States are: Ohio, Alaska, Delaware, Nevada, Rhode Island, Utah, South Dakota, Missouri,Oklahoma, Tennessee, Wyoming and New Hampshire. The terms of these trusts are similar to those of the FAPT. The specifics of each State’s APT statute vary substantially and each State may offer advantages or disadvantages for a particular person or situation. Each person considering a domestic APT should review their potential exposure to liability and seek legal advice on which State is best for their situation.
This may be more comfortable to some persons than a FAPT since your assets are still within the U.S. However, being within the U.S. legal system will result in less asset protection. Plaintiff’s lawyers are very creative in formulating new theories of recovery and judges with an inclination to expand plaintiff’s remedies will find a way to do so. The I.R.S. and other government agencies will also have powerful legal means at their disposal within the U.S. legal system. The obstacles to a lawsuit against a FAPT are not present for a domestic APT. A motivated creditor will certainly initiate a lawsuit and attempt to enforce their judgment against this type of trust.
- Constitutional Issues
There is also some legal debate over whether these trusts will even be effective against a creditor attack after judgment. The reason is due to the “full faith and credit” clause of the U. S. Constitution. The U.S. Constitution provides in the full faith and credit clause as follows:”Full faith and credit shall be given in the States to the public acts, records, and judicial proceedings of every other state.”
The applicability of the full faith and credit clause arises in the context of a domestic APT in the following situations:
- A creditor of an Ohio grantor of a Delaware trust obtains a judgment in Ohio against the grantor. The creditor then goes to Delaware and attempts to enforce a judgment against the Delaware trust. Does a Delaware Court have to recognize this Ohio judgment giving it full faith and credit by permitting collection against the Delaware trust?
- A creditor of an Ohio grantor of a Delaware trust sues the Delaware trustee in Ohio attempting to obtain the judgment against the trust. In order to sue a Delaware trustee outside Delaware, the creditor must obtain jurisdiction over the trustee. In order to do so, the trustee must have some physical presence or other connection to the other state. If the court somehow does obtain jurisdiction over the trustee, then the court has to consider whether to apply the law of its own state or the law of Delaware to the trust.
The conflict of law principles governing trusts that is relevant here states as follows:
“The trust is valid if it is valid under the local law of the state designated by the Settlor to govern the validity of the trust provided that this state has a substantial relation to the trust and that application of its law does not violate the strong public policy of this state.”
In the context of an APT, the interpretation may be that the policy of the state of Ohio does not allow a self-settled trust to avoid creditor claims. Thus, the law of Delaware will not be applied and Ohio law will be applied to allow the creditors claim. A contrary view would be that Delaware law applies since the trust is governed by Delaware law and administered by a Delaware trustee.
In the context of a bankruptcy, third party spendthrift trusts have been held to be excluded from the bankruptcy estate. A domestic APT may also be excluded from the bankruptcy estate under the same provision. However, the new BAPA ten-year fraudulent transfer provision for self-settled trusts discussed above clearly applies to domestic APT and could defeat such APT in bankruptcy.
Legal commentators disagree on the answers to the above full faith and credit clause questions and we will probably not know the answer until this is decided by the U. S. Supreme Court. In conclusion, the domestic APT is a possible planning option but the full faith and credit clause issue casts a cloud of uncertainty over the effectiveness of this plan.
© 2015 Michael Millonig, LLC