Domestic Asset Protection Trusts – A good choice for Californians?

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What you do not own your creditors cannot reach. It’s as simple as that. Most people would not consider gifts to others a desirable strategy to avoid creditors. Better options are, for example, marital transmutation agreements and properly structured irrevocable trusts.

Conventional asset protection strategies

Marital transmutation agreements convert assets previously owned jointly by a couple to assets that exclusively belong to one spouse or the other. This works unless the transmutation was a voidable conveyance, to be discussed below. If the couple splits, the scheme fails, at least from the perspective of the spouse who transferred assets to the other spouse.

Assets in so-called irrevocable spendthrift trusts are also protected, unless funds in them are distributed. Importantly, they have a third party as beneficiary (i.e., they are not self-settled, see below) and may fail if not properly structured. More protection can be obtained when the trustee has absolute discretion over the distribution of income or principal. In consequence, the beneficiary is at the mercy of the trustee. 

Self-settled trust for asset protection? The perfect solution?

Giving up control over assets one once owned is not a whole lot better than giving them to creditors. Could we instead give away assets, avoid creditors, while in some form still retaining control, and be able to revoke the transfer?

This is the promise of the so-called self-settled trusts. A self-settled trust is a type of trust in which the trustmaker (also known as the grantor or settlor) places assets into a trust and names themselves as a beneficiary. This setup allows the trustmaker to potentially shield assets from creditors while still benefiting from those assets, under certain conditions. The key characteristic of a self-settled trust, in this context, is the grantor’s dual role as both the person who creates the trust and one of its beneficiaries.
Self-settled trusts are often called Domestic Asset Protection Trusts (DAPT), although none of them are called by this name in the respective legislation of the states that allow them. Currently, there are nineteen, and California is not one of them.

Revocable Living Trusts are also self-settled. Why can’t they be used for asset protection?

The short answer is, because they are revocable. The following table shows the differences.

Feature DAPTs Revocable Living Trusts
Irrevocability and Control Irrevocable trusts, cannot be modified or revoked without consent of another party. Provides asset protection as assets are not under direct control of the settlor. Can be altered or revoked by the settlor at any time, allowing settlor to maintain control over assets. Assets are not protected from creditors.
Asset Protection Designed to protect assets from future creditors. Assets are generally beyond reach of creditors if properly structured and funded before creditor issues arise. Do not provide asset protection for the settlor due to the ability to revoke the trust and regain possession of assets.
Estate Planning Used as part of an estate plan with primary purpose being asset protection. Primarily used for avoiding probate, maintaining privacy, and managing assets during incapacity or after death.
Tax Considerations Assets may be subject to gift tax at transfer and designed to remove assets from settlor’s taxable estate. Considered transparent for tax purposes, with settlor treated as owner of assets for income and estate tax purposes.
Jurisdiction Available only in certain states with specific legislation. Can be established in any state, common across the United States.

Do self-settled Asset Protection Trusts work anywhere?

California is one of the majority of states that do not allow self-settled trusts.  Worse, it has a public policy against such self-settled trusts. Generally, California courts may gain jurisdiction over the assets in a trust in another state if a substantial relationship exists between California and the trust at the time it was created. This relationship can exist because 1) the trustee or settlor is domiciled in California, 2) the assets are located in California, or 3) the beneficiaries are domiciled in California. This creates multiple ways the long arm of the law can reach another state.

A long battle between creditor and debtor with an uncertain outcome

The state where the DAPT trust is located may, however, refuse to enforce a California judgment if it is against that state’s policy. This suggests that a creditor’s attempt to access funds in a DAPT (self-settled trust) may require a lengthy court battle with uncertain outcome. On the flip side, defending against a lengthy creditor suit will also create costs for you, the debtor.  Attorneys who advise clients setting up such trusts have an ever-changing ‘ranking’ of states based on the perceived strength of their asset protection laws which are subject to constant fluctuations. “There was a point when we liked Delaware the best, and then there was a time when we liked Nevada the best. Each of these states has recently had court decisions diminish the protection their laws offer, so they are no longer our preferred domestic jurisdiction.” Source.

All things considered, for asset protection for a client domiciled in California, a DAPT would not necessarily be our first choice.

Voidable conveyances aka ‘fraudulent transfers’

In the first paragraph we promised that we would explain what voidable conveyances are. Many use the word ‘fraudulent transfer’ as a synonym, but this is neither polite nor completely correct, because it is fraudulent only when the transfer is made with the actual intent of “delaying, defeating or hindering” any creditor (the actual intent test). Asset transfers can also be voided for certain gratuitous transfers, or a transfer for less than fair market value and when the debtor is either insolvent at the time of the transfer or is left insolvent (no intent needs to be shown).

To give an example, if you know that your creditors are after you, it is too late to set up an asset protection vehicle (in whichever form), since any transfer into it could be reversed (voided).

See also:
Trusts – A general overview
Comparison of California Wills, Revocable and Irrevocable Trusts

 

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