If you read all the asset protection cases out there, you will find that there are really only three ways to attack a well crafted asset protection trust: (1) attempt to prove that the transfers to the trust were fraudulent transfers, (2) attack a self-settled asset protection trust by using the laws of a state or jurisdiction that doesn’t recognize self-settled trusts, or (3) attack the trust based on several related theories referred to as reverse veil piercing, alter-ego, constructive trust, or the sham transaction theory. For purposes of this article, the third category will be referred to as “veil piercing.”
It is easy to completely avoid and prevent an attack based on a fraudulent transfer theory. You simply transfer your assets to your asset protection trust in advance of a problem, lawsuit, or bankruptcy. Note that the courts analyze fraudulent transfers based on if a prudent person in your situation might or could have foreseen liability given the circumstances.
For example, in Albee v. Krasnoff, Mr. Krasnoff was a fifty percent owner of an investment partnership with hundreds of investors. Mr. Krasnoff conveyed a home to an irrevocable trust for his wife. Five years later it was discovered that Mr. Krasnoff’s partner had embezzled money from the partnership. All the investors lost money and sued the partnership as well as Mr. Krasnoff and his partner. The investors argued that the transfer to the trust was fraudulent because it occurred after the investment had been made, but the court ruled that the transfer was not fraudulent because it was done for estate planning purposes and Mr. Krasnoff had no knowledge of the fraud or the potential claim when the transfer was made.
In another court case called, In the Matter of Damrow, the court examined two separate transfers by the same person, and the court found that one of them constituted a fraudulent transfer, and the other did not. When the first transfer was made, in January of the year 2000, Mr. Damrow had guaranteed significant loans to several lenders, but he was not behind on payments. When the second transfer was made, in November of 2001, Mr. Damrow was behind on payments and several creditors had initiated collection activities. The court found that the second transfer was fraudulent because Mr. Damrow was insolvent when he made it, and the first transfer was not fraudulent because he was not insolvent when the first transfer was made.
If you make a transfer with actual intent to hinder, delay, or defraud a creditor, or if you make a transfer at a time and under circumstances that appear to be a fraudulent transfer, then a creditor can obtain a judgment against the trust regardless of how well the trust is designed and drafted. Countless court cases make it unmistakably clear that no asset protection trust, domestic or offshore, can be relied upon to protect assets if the transfers are made at a time and under circumstances that are likely to result in a fraudulent transfer.
Even if you do have a current lawsuit or judgment against you, you may be able to make a transfer to an asset protection trust that is not a fraudulent transfer if you retain sufficient assets in your name to satisfy the pending judgment. The test that is used to determine if a transfer is fraudulent is based on your specific facts and circumstances. If you have any question whether a transfer could be considered fraudulent, you should consult legal counsel regarding your specific situation.
In summary, the best way to defend against a fraudulent transfer attack is to create and fund your asset protection trust at a time when you are not insolvent, the transfer does not render you insolvent, you have no judgments against you, you are not behind on payments, and you have no reason to believe that substantial liabilities or judgments are imminent. If you do so, the fraudulent transfer attack is avoided and you can move on to the next phase of the analysis.
The common law rule in the United States has always been that if a settlor is also a beneficiary of a trust, the settlor’s creditors can reach the maximum amount which the trustee can pay to the settlor. (See Restatement (Second) of Trusts, Section 156 and Uniform Trust Code Section 505). Over the past thirty years, several domestic and offshore jurisdictions have passed statutory laws providing that the assets of a self-settled trust (a trust in which the settlor is also a beneficiary) are protected from creditors. Almost all offshore and domestic asset protection trusts are based on these new laws which provide asset protection for a self-settled trust.
If you create a self-settled asset protection trust in a supportive jurisdiction, a creditor could attack your trust by arguing that the law of a different jurisdiction applies. For example, if you create a Delaware asset protection trust, a creditor from New York may argue that New York law applies instead of Delaware law because the offense occurred in New York and the offended party is a resident of New York. Because the laws of the State of New York do not allow a debtor to protect assets in a self-settled trust, the New York courts could potentially allow a New York resident to obtain a judgment against the trust. Similarly, it is possible that a federal court (including a bankruptcy court) could refuse to recognize the laws of a jurisdiction that provides asset protection for a self-settled trust. Because domestic self-settled asset protection trusts have only been around for 13 years, there are no court cases on this issue at the present time. There are however, two federal bankruptcy cases where the bankruptcy court has refused to recognize the self-settled trust laws of a foreign jurisdiction because it is against the policy of the federal bankruptcy courts.
In the Portnoy case cited above, Judge Brozman of the Federal Bankruptcy court said, “I think it probably goes without saying that it would offend our policies to permit a debtor to shield from creditors all of his assets because ownership is technically held in a self-settled trust.”
In Dexia Credit Local v. Rogan, Dexia sued Peter Rogan for fraud, conspiracy, and other torts and obtained a judgment against him for $124,000,000. Rogan had established a trust under Bahamian law which protects the assets of a self-settled trust from the creditors of the grantor. The Illinois court said that it would not honor the laws of a jurisdiction where doing so would violate the public policy of the State of Illinois.
You can avoid an attack based on a self-settled trust theory by simply not using a self-settled trust. If you create an irrevocable trust for your spouse and children and you are not included as a beneficiary, the risk of an attack based on a self-settled trust theory is completely eliminated.
There are other ways that you can potentially receive benefits from a trust without being included as a beneficiary. For example, you could receive a salary for managing companies owned by a trust. Or, the trust could provide distributions to your spouse, which your spouse could later transfer to you as a gift or allow you to enjoy as a collateral benefit of being married to a wealthy spouse. Another option is to grant your spouse or some other person a special power of appointment. This is a power to appoint the assets of a trust to anyone except for the person who holds the power (or their estate or their creditors). The special power of appointment could be used to provide benefits to you if necessary, even though you are not a beneficiary of the trust. Many statutes and cases support the fact that a special power of appointment does not create creditor rights.
In summary, you can avoid an attack based on a self-settled trust theory by not using a self-settled trust. However, this creates other risks because it means that you are left out as a beneficiary. The best way to solve this problem is to include a special power of appointment in the trust, and design a system of trustees and trust protectors that ensures that no person has power to abuse the trust.
The only other way to attack an asset protection trust is to argue that the trust is not to be respected as a separate legal entity from the debtor. This attack is often referred to as reverse veil piercing, alter-ego, constructive trust, or the sham transaction theory. There are many court cases discussing and applying these theories to determine if a creditor can pierce an irrevocable trust.
For example, in Dean v. United States, George and Catherine Mossie established an irrevocable trust for the benefit of their children for estate planning purposes. They transferred assets to the trust on December 4, 1990. At the time the transfer was made, they were not aware that their tax return from 1988 was being audited. Later the IRS, audited all their returns from 1987 to 1990 and assessed back taxes and penalties against the Mossies in the amount of $281,093.95. The IRS placed a federal tax lien on the assets of the trust by claiming that it was the alter-ego of the Mossies, and the trustees sued to have the lien removed.
It is interesting to note the following facts pertaining to the alter-ego analysis:
- Except for a brief period at the beginning of the trust when Catherine Mossie used her personal checking account to pay rental expenses for the trust property, all trust checks were signed by the trustees and not the Mossies.
- All deeds, transfer documents, tax returns, and promissory notes pertaining to the trust were signed by the trustees.
- All management decisions concerning the trust were made by the trustees.
- The trustees did allow Catherine Mossie to live in a home owned by the trust without rent.
- The trust owns a car which it makes available for the personal use of George and Catherine Mossie.
- The trust owns a vacation home which it has made available to Catherine without rent, once or twice.
- George and Catherine Mossie have received no money from the trust, except for reimbursement for nominal trust expenses paid by the Mossies.
- The trustees were two of the Mossie’s four daughters.
The court recited the general rule for applying the alter-ego doctrine which is that a separate entity will be respected unless it was so dominated that it had “no separate mind, will or existence of its own.” The court found that the Mossies had established the trust for legitimate estate planning purposes and that the legal control of the trust assets had shifted to the trustees. It is true that the trustees had allowed the Mossies to receive some collateral benefits from the trust but the court said that is how families do function and should function and small deviations from the trust are not enough to invalidate the whole trust. In the end, the court ordered the IRS to return the trust property to the trustees and release the tax liens against the trust property.
Another example is the case called, In re Vebeliunas. In the Vebeliunas case, a wife established an irrevocable trust for her husband (the “debtor”), naming herself as the sole trustee. The court found that the creditor was not able to pierce the veil of the trust, despite the following facts: (1) the debtor was indicted for fraud, (2) the debtor filed for bankruptcy to obtain relief from his creditors, (3) the bankruptcy court sought to have the debtor declared the alter ego of the trust and to have the trust assets treated as part of debtor’s bankruptcy estate, (4) the debtor’s family received and retained rent proceeds from trust, (5) the debtor and his family lived on property owned by the trust without paying rent to the trust; (6) the debtor granted easements on property owned by the trust, (7) the debtor and his wife deducted from their personal tax returns real estate taxes and interest expenses relating to the trust, (8) the debtor granted mortgages on property owned by the trust, (9) the debtor pledged the trust property in order to obtain bail in his criminal case; and (10) the debtor represented to several banks that his revocable trust owned the property which was actually owned by the irrevocable trust. Although the debtor probably pushed the limits of dominion and control over the trust in this case, this case illustrates the fact that a court will generally uphold an irrevocable trust as a separate and distinct legal entity unless the debtor exerts so much dominion over the trust that it has no separate identity.
Similarly, in Miller v. Kresser, a mother created a trust for her son and named another son as the trustee. The beneficiary son was sued for over $1,000,000. The trial court found that the beneficiary son exerted significant control over the trust by taking money out without the trustee’s knowledge, dominating investment decisions, and keeping possession of the trust checkbook. The Florida 4th District Court of Appeals upheld the creditor protection provided by the trust even though “the facts in this case are perhaps the most egregious example of a trustee abdicating his responsibilities . . . the law requires that the focus must be on the terms of the trust . . . and the trust did not give the beneficiary any authority whatsoever to manage or distribute trust property.”
We think these cases demonstrate the fact that a court will generally uphold the separate existence of a trust, just as they generally uphold the separate existence of a corporation, unless the facts are so egregious as to indicate a total disregard of the legal entity so that it becomes the alter-ego of the debtor.
The solution to avoiding these attacks is really quite simple: (1) the trustee should demonstrate control over the trust and abide by the terms of the trust instrument, (2) the presence of an independent trustee is not required, but it goes a long way to show that the trust is a separate legal entity from the grantor or the beneficiaries, (3) the grantor and beneficiaries should not exert so much control or dominion so that they appear to be the owners of the trust assets, (4) the benefits of the trust should be reserved for the beneficiaries, and (5) transactions with the trust should be on the same terms as would be expected between unrelated parties.
Another way to defend against the veil piercing type of attack is to locate the trust in a state with greater asset protection laws. Currently, the best states are Nevada, Alaska, and South Dakota. A person in any state can create a trust in one of these locations by appointing a trustee in the state where they want the trust to be located. Consider the language of these Nevada Statutes which are designed to protect against a veil piercing attack:
NRS 163.4177 Factors which must not be considered exercising improper dominion or control over trust. If a party asserts that a beneficiary or settlor is exercising improper dominion or control over a trust, the following factors, alone or in combination, must not be considered exercising improper dominion or control over a trust:
- A beneficiary is serving as a trustee.
- The settlor or beneficiary holds unrestricted power to remove or replace a trustee.
- The settlor or beneficiary is a trust administrator, general partner of a partnership, manager of a limited-liability company, officer of a corporation or any other manager of any other type of entity and all or part of the trust property consists of an interest in the entity.
- The trustee is a person related by blood, adoption or marriage to the settlor or beneficiary.
- The trustee is the settlor or beneficiary’s agent, accountant, attorney, financial adviser or friend.
- The trustee is a business associate of the settlor or beneficiary.
NRS 163.418 Clear and convincing evidence required to find settlor to be alter ego of trustee of irrevocable trust; certain factors insufficient for finding that settlor controls or is alter ego of trustee of irrevocable trust. Absent clear and convincing evidence, a settlor of an irrevocable trust shall not be deemed to be the alter ego of a trustee of an irrevocable trust. If a party asserts that a settlor of an irrevocable trust is the alter ego of a trustee of the trust, the following factors, alone or in combination, are not sufficient evidence for a court to find that the settlor controls or is the alter ego of a trustee:
- The settlor has signed checks, made disbursements or executed other documents related to the trust as the trustee and the settlor is not a trustee, if the settlor has done so in isolated incidents.
- The settlor has made requests for distributions on behalf of a beneficiary.
- The settlor has made requests for the trustee to hold, purchase or sell any trust property.
- The settlor has engaged in any one of the activities, alone or in combination, listed in NRS 163.4177.
In our experience, most properly designed asset protection trusts are never discovered in the first place. If you are sued or subject to some kind of unexpected liability, the creditor will ask for your personal financial statements. Because you have no ownership in the trust or its assets, they should not be included on your personal financial statements. If your trust is funded more than two years before you file bankruptcy, the trust is usually not discovered through a typical bankruptcy proceeding.
Although an asset protection trust is not discovered in the majority of cases, one should never rely solely on secrecy to defend against every attack. A sophisticated creditor can always get you under oath and ask enough of the right questions to discover the trust. If that happens to you, you should always answer honestly and with confidence that your trust was established for appropriate purposes and that it will hold up on its own merits. The best asset protection trust has the following characteristics: (1) it is funded in advance of a problem, (2) it is created for legitimate estate planning purposes, (3) it is an irrevocable trust that does not include the grantor as a beneficiary, (4) it includes an independent professional trustee in the State of Nevada (although it is possible to use a family member or friend in your home state as long as the parties respect the trust as a separate legal entity), and (5) it includes a special power of appointment which provides flexibility to the trust despite the fact that the trust is irrevocable.
 566 SE 2d 455 (Ga.Ct. Appeals 2002).
 Case No. BK02-43392 (Bankr.Neb. 3/13/2007) (Bankr.Neb., 2007).
 See In re Portnoy, 201 B.R. 698, and In re Brooks, 217 B.R. 98.
 In re Portnoy at 700.
 624 F. Supp. 2d 970 (N.D. Illinois 2009).
 See US Bankruptcy Code Section 541(b)(1), California Probate Code Section 681, Delaware Code Section 3536, In Estate of German, 7 Cl. Ct. 641 (1985) (85-1 USTC Par 13,610 (CCH), In re Hicks, 22 B.R. 243 (Bankr. N.D.Ga.1982), In re Knight, 164 B.R. 372 (Bankr.S.D.Fla.1994), RESTATEMENT OF THE LAW (SECOND) PROPERTY, Section 13.6.
 987 F. Supp. 1160 (December 4, 1997).
 332 f. 3D 85 (Ct. Appeals 2nd Cir. 2003).
 2010 Fla. App Lexis 6152.