Let’s face it. We live in an increasingly litigious society. For proof of this, just watch television for a few minutes and count how many advertisements you see for lawyers wanting you to sue someone. As a result of this, a question commonly asked of us is, “Can I protect my assets from lawsuits or creditors?” In Tennessee, the answer now appears to be yes.
The Tennessee Investment Services Act of 2007 allows a person to create a trust for the benefit of himself which is also protected from his creditors. The trust can also be structured to benefit his family. This type of trust has become commonly referred to as a Domestic Asset Protection Trust (or “DAPT”).
History of Asset Protection Trusts
For hundreds of years, the general rule in the U.S. is that where a person creates a trust for his own benefit, provisions which attempt to protect the trust assets from his creditors are void. It has generally been impossible to create a trust for yourself and protect the assets from your creditors.
In contrast to a trust for oneself, protection of trust assets for the benefit of a beneficiary other than the Grantor can be easily accomplished. For example, John can create a trust for Linda, giving the Trustee the authority to distribute income or principal for the health, support, and care of Linda but, at the same time, protect the assets from Linda’s creditors (or others who would seek to take the assets away from Linda). In the past, the law has not allowed John to create the trust for his own benefit and protect the assets from his creditors.
In an effort to find a haven where one could shelter assets them from creditors, some turned to offshore trusts. For most, offshore trusts are not an attractive option. First, such trusts have a bad reputation. Some have used offshore trusts to improperly avoid income tax on trust earnings. The IRS has vigorously pursued those individuals. Transferring funds to foreign countries, structuring a trust document under foreign country tax laws and placing one’s assets outside of the U.S. produces an uncomfortable feeling for most. There is financial risk of political change in a foreign country. There is a valid concern that if the creditors cannot get the assets, whether you will be able to reach them.
As a result of money moving into offshore trusts, certain states began to change their laws to allow self settled Asset Protection Trusts in the United States. In 1997, Alaska was the first state to pass such asset protection law. The Alaska law allowed a Grantor to transfer assets to a trust company located in Alaska and protect the assets from the Grantor’s creditors. Delaware and Nevada followed with similar asset protection statutes. Rhode Island, Utah, Missouri, and Wyoming subsequently passed statutes providing for lesser degrees of asset protection for Grantors. As mentioned above, Tennessee joined those states in 2007.
Constitutional and Other Problems
Prior to the Tennessee law in 2007, certain questions remained unresolved, however, relative to whether a Tennessee court would recognize the application and validity of the Alaska law in protecting your assets from a lawsuit in Tennessee. For example, a Tennessee Court might have issued a court order telling a person to bring the trust assets back from Alaska. If the person did not do so, he could possibly be held in contempt of court and subject to jail time. That result is similar to what happened to the defendant in the offshore trust case of FTC v. Affordable Media, LLC.
There is also some concern that the Full Faith and Credit clause of the U.S. Constitution would require Alaska to recognize a valid judgment from Tennessee, thus rendering the Asset Protection Trust useless. Additionally, if the assets were for some reason not located in the Asset Protection State, they would not be protected by the Asset Protection State’s laws.
Because of the distances involved and the unanswered constitutional questions, most Tennessee residents found the utilization of an Alaska trust, a Delaware trust, or Nevada trust unacceptable. With the passage of a law in Tennessee, most of the issues have disappeared.
Tennessee Asset Protection Trusts
In order to establish an Asset Protection Trust under the laws of Tennessee, a number of criteria must be met. First, the trust must be irrevocable. This means such a trust cannot be lightly considered. Decisions need to be made as to the beneficiaries of the trust, the trust provisions, when the trust ends, and how the trust assets are to be managed.
The trust must have its situs or residence in Tennessee. The majority of the assets must be located and housed in Tennessee. It is recommended that all assets be located and managed in Tennessee.
The trust must meet stringent requirements regarding the structure of the trust. Specific language must be included in the trust that provides that the interest of the Grantor and other beneficiaries may not be transferred, assigned, pledged, or mortgaged. Once the assets are placed in the trust, they cannot be used to secure any debt of the Grantor.
Upon establishing the trust, the Grantor must show that he has a full right, title, and authority to transfer the assets into the trust, that the transfer will not render the Grantor insolvent, that the transfer is not intended to defraud creditors, and that the Grantor does not have any pending or threatened court actions against the Grantor except those as may be fully disclosed in the process of establishing the trust.
Likewise, the Grantor must show that he is not involved in any administrative proceedings such as an EPA investigation, except as may be fully disclosed, that the Grantor does not contemplate filing bankruptcy and that the assets are not derived from any unlawful activities.
Asset Protection Trusts have multiple income, gift, and tax issues that must be considered.
Income Tax Issues. Because the income of the trust “may” be paid to or for the benefit of the Grantor, the trust is deemed to be a Grantor Trust for income tax law. What this means is that all income of the trust is taxed to the Grantor. Even if the income is paid to a spouse, a child, or other beneficiary, the Grantor pays income tax on the income. If the income is retained in the trust, the Grantor pays tax on that income as well.
Gift Tax Issues. Because the trust is an irrevocable trust, there are immediate gift tax concerns that must be addressed at the formation of the trust. The trick is to structure the trust so that no taxable gift is made at the time of formation. This requires expert tax advice. Distributions to children during the life of the Grantor will be taxable gifts as well.
Estate Tax Issues. Because the trust income or principal “may” be paid to or for the benefit of the Grantor, the trust is generally included in the estate of the Grantor for estate tax purposes. In addition, other powers which the Grantor will likely retain and which are discussed below result in the trust assets being taxed in the estate of the Grantor at the Grantor’s later death. Because the assets are taxed when the Grantor dies, the structure of the trust and how it is to be administered and managed following the death of the Grantor are extremely important.
Distribution Provisions for the Grantor
Common law generally provides for three types of trusts. The first type of trust is a mandatory trust. An example of this would be a trust that requires all income to be paid to the beneficiary.
The second type of trust is a support trust, that is, a trust which requires the income or principal to be distributed for the health, education, maintenance, or support of a beneficiary as needed.
The third type of trust is a discretionary trust. A discretionary trust is one which gives the Trustee very broad discretion as to whether or not to pay income or principal to a beneficiary and when to pay it.
The benefits provided by an Asset Protection Trust are more limited in mandatory trusts and far greater as the trust moves from a mandatory trust to a support trust and then to a discretionary trust. If the trust requires the payment of income to the Grantor, then once the income is received by the Grantor, the creditor can attach it. Accordingly, using a discretionary trust and giving the Trustee broad discretion as to whether or not income and/or principal should be paid to the Grantor or used for the benefit of the Grantor adds to the protection otherwise available.
Generally. The big question that will be asked with most Asset Protection Trusts is whether or not the Grantor established the trust with the intent of defrauding existing or future creditors.
Existing Creditors. The law gives creditors existing at the time of a transfer to the trust the lesser of (a) two (2) years from the date the transfer was made and (b) six (6) months from the date the transfer or obligation was discovered or could have been reasonably discovered to commence an action against the Grantor and the Trustee to rescind the transfer.
New Creditors. Creditors whose claims arose after the creation of the trust have two (2) from the date of the transfer to the trust to commence an action against the Grantor and the Trustee to rescind the transfer.
Shortening the Time to File – Notice. The law also allows the Grantor to shorten the two year period to as little as six (6) months by giving notice. Any public notice of a transfer to a trust is deemed to be actual notice to the creditor. This can be satisfied by recording the transfer in the local register’s office.
High Burden Placed upon Creditors to Prove the Transfer Fraudulent. If a creditor wishes to attempt to rescind a transfer made to a trust, then the creditor must not only file suit, but also prove that the Grantor of the trust made the transfer with the intent to defraud that specific creditor. Additionally, the standard of proof is substantial and highly unfavourable to the creditor. The general standard of proof in civil actions is a “preponderance of the evidence” which simply means “more likely than not.” In this case, the standard is “clear and convincing” which is somewhat less than the criminal standard of “beyond a reasonable doubt,” but substantially more than the “more likely than not” standard.
Bankruptcy. If a trust creator is forced into bankruptcy, creditors from before the trust was funded and creditors from after the trust was funded may reach the trust assets for ten (10) years from when the trust was funded if they can show that the transfer was made with the intent to “hinder, delay, or defraud” creditors. In Battley v. Mortensen, a 2011 bankruptcy case out of Alaska, the court found this standard was met because a stated purpose in the trust agreement was to “maximize the protection of the trust estate or estates from the creditor’s claims.”
None of this is important if the trust was not established with the intent to hinder, delay, or defraud existing or future creditors. The law provides clear guidelines which allow for the establishment of such a trust. If the guidelines are followed, the trust assets are protected. If the intent of the Grantor was to defraud creditors, the trust will be of little benefit.
Perhaps the most significant question to be resolved after those associated with the formation and terms of the trust is naming a Trustee. The Grantor cannot be his own Trustee. The Grantor should not have a straw man Trustee, that is, someone who simply acts for the Grantor and allows the Grantor to truly control and manage the trust.
In an effort to retain control, there is a tendency to want to appoint some family member as the Trustee. Appointing one’s brother may sound like a good idea but if the brother does not appropriately administer the trust, and he likely will not because he does not fully understand or appreciate the rules, the trust may fail to protect anything.
Naming a spouse as a Trustee may sound like a good idea until a divorce. Naming a child may also sound like a good idea until the child realizes that for every dollar he distributes to the parent, he has lost a dollar in inheritance.
The law requires expertise in administering the trust correctly. The question that must be resolved is whether a court will give more weight to an Independent Trustee’s or Corporate Trustee’s actions to help you protect your assets or whether a court will look at the technique as a sham run by you, your child, your brother, or your best friend. Will your buddy step up to the plate and fight with you to protect the trust assets when he, as Trustee, gets sued by the creditor?
For the reasons above, it is strongly suggested that consideration be given to using a professional Independent or Corporate Trustee to manage and administer Asset Protection Trusts. Utilizing family and friends is not recommended.
Powers You Can Keep
As the Grantor, you can retain a number of powers. First, you can retain the power to direct the investments. This gives you control over how the trust assets are managed. You can also retain the power to veto a distribution to any other beneficiary, such as a child. You can retain the power at death to adjust the distribution provisions of the trust and direct the assets at death to a predetermined group of persons whom you desire to receive the assets.
The Grantor can receive trust income and demand up to 5% of the trust principal each year. Otherwise, distributions of income and principal are and should be in the discretion of the Trustee.
An Asset Protection Trust can own a home, a vacation home, and any other assets. However, non-retirement related investment assets, such as stocks and bonds, represent the best possible assets to place in such a trust.
The Grantor can also retain the right to remove the Trustee and appoint a Successor Trustee and remove trust financial advisors and appoint successor financial advisors.
Non-Tennessee residents, such as those in Kentucky, Indiana, Arkansas, Mississippi, and Alabama, can establish a Tennessee Asset Protection Trust. In doing so, they subject themselves to Tennessee law. The concerns that exist relate to whether or not the Mississippi courts, for instance, will recognize the validity of the Tennessee asset protection statute with respect to a Mississippi resident who has creditor problems in the future.
Based on 10 years of experience in the administration of the Alaska and Delaware laws which are very similar to the Tennessee law, we have no reason to believe that the Mississippi courts will not give full faith and credit to the Tennessee law if the assets are properly held in Tennessee, especially by an Independent Corporate Trustee.
Domestic Asset Protection Trusts are still a relatively new animal. There will continue to be court decisions rendered in Tennessee and the other DAPT states interpreting the laws, how they work, and the extent to which they work. The law is not designed to allow you to place all of your assets in such a trust. It is designed to let you place a portion of your assets into your trust, presumably non-retirement related investment assets which make up a part of your overall estate.
The trust is not a vehicle which allows you to cancel your liability insurance coverage. If sued, you still need to defend the lawsuit. The trust does not protect you from lawsuits and it does not prevent someone from garnishing your wages or income. The trust only protects the trust assets from attachment by creditors if someone gets a judgment against you.
An Asset Protection Trust should be only one part of your overall financial and estate plan. Established and administered correctly, it should protect assets for that rainy day when all else may be lost.
What we know is that without an Asset Protection Trust, your assets are subject to claims of your creditors. With a properly structured and administered Asset Protection Trust, they should be protected. Properly structured, an Asset Protection Trust can be a valuable addition to your overall estate and financial plan.
C. Michael Adams and Robert D. Malin (2014)
Memphis, Tennessee 38120