Asset Protection

Domestic Asset Protection Trusts

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This is a part in a series of articles I have written on various types of irrevocable trusts.

What is DAPT?

One of the most unique forms of irrevocable trusts is a Domestic Asset Protection Trust (DAPT), otherwise referred to as a self-settled spendthrift trust.  With most irrevocable trusts, the person setting it up (the grantor) names someone else as the beneficiary. What sets the DAPT apart is that a DAPT is an irrevocable trust in which the grantor is also a beneficiary of the trust, while still providing asset protection during the grantor’s lifetime. A hybrid-DAPT is one in which the grantor is not necessarily named as a beneficiary upfront in the trust but can be added back in at a later point. This can offer an even greater amount of asset protection.

The most ideal assets to place into a DAPT are those most valuable to a client and, by definition, to a potential creditor. Many people will transfer cash, bank accounts, and brokerage accounts into a DAPT.

Theory Behind Asset Protection

In a typical revocable trust, there is no asset protection. First, the grantor generally is the trustee and the beneficiary and thus can readily access the assets at any time. Secondly, because the trust is amendable, the grantor can change the trust for any reason. Therefore, the trust assets are readily available to the grantor and, by definition, the grantor’s creditors. 

An irrevocable trust does offer asset protection since the trust cannot be changed once created, and distribution of any trust assets to the beneficiaries is made by an independent third party trustee, not through the grantor. In a DAPT, though, the grantor can also be a beneficiary. While the grantor may be given certain powers to modify the enjoyment of the trust assets, and while the grantor may also be named as an investment trustee (to control how the trust assets are invested), any distributions from the trust must go through a third-party distribution trustee.

When it comes to asset protection, it is unrealistic to believe that an irrevocable trust avoids any lawsuits. Rather, a reasonable goal of any asset protection strategy is to put obstacles in the way of any potential creditors. By doing so, there will be no low-lying fruit for creditors to grab easily. Instead, when a creditor sees the structures you have put into place, they must consider the cost-benefit analysis of pursuing a lawsuit versus agreeing to a settlement on the debtor’s terms. Thus, a good asset protection strategy is one that shifts the terms of any settlement in your favor. 

Meet the Cast

A DAPT can star several leading roles but the most important ones involve the nature of the office of trustee, which can be broken down into three types of trustees.

First, the investment trustee is the person who determines what the trust buys, sells, holds, and invests. The investment trustee in a DAPT can be the grantor, which is a tremendous power that can be retained legally by the trust creator.

Second, the distribution trustee is the person or company in charge of distributing assets to the trust beneficiaries or on behalf of the beneficiaries. The distribution trustee also determines when distributions should be made. The grantor cannot retain this power and thus, it is very common that a corporate trustee be named as the distribution trustee.

Third is the administrative trustee. This person or company maintains the records and administrative affairs of the trust, including undertaking all administrative responsibilities of the trust, such as filing annual tax returns. Again, it is common for the trust company to not only serve as the distribution trustee but also the administrative trustee.

A state like Nevada requires that at least one of the trustees is a Nevada resident.

Not all States are Created Equal

Less than only twenty states in the nation permit DAPT trusts. This means that if you attempted to build a DAPT trust in any other state, there would be no recognized protection against creditors in those states. But in a DAPT jurisdiction, there are statutes that not only recognize and permit DAPT trusts, but also offer varying degrees of asset protection to the grantor.

Among the leading DAPT jurisdictions is Nevada. For over two decades, Nevada has passed laws ensuring it is the top trust jurisdiction for asset protection.  What makes a DAPT trust in Nevada far superior than other DAPT jurisdictions are a variety of factors, including:

  • Two-year limitations period – This is the time that must elapse between the transfer of assets to the trust and the time when those assets should be protected from creditors. In other words, a creditor that files a lawsuit beyond the statute of limitations period is barred from suing the trust. There is a distinction between pre-existing creditors and future creditors. Nevada has a two-year statute of limitations against future creditors, which is one of the shortest in the nation. With respect to pre-existing creditors, there is always a tolling period, which is “extra time” given to protect an unbeknownst creditor to still file a claim upon knowledge of an injury or transfer to the trust. In Nevada, the tolling period is only six months. In practical terms, this means that the statute of limitations in Nevada for pre-existing creditors is the longer of two years from the date of transfer to the DAPT or six months from the date that the creditor discovered or reasonably should have discovered the transfer to the trust. Nevada is just one of a handful of states that has a special provision that allows for the six month tolling to begin on the date of transfer by making the assignment of the trust a matter of public record. This means the six month tolling runs out within the two year statute of limitations period, which effectively means Nevada has just a flat two years statute of limitations period even to a pre-existing creditor.
  • Clear and convincing evidence – Normally if it can be proven that assets were transferred to a trust with the intent to “hinder, defraud, or delay” an existing creditor, then the transferred assets are not protected and can be unwound. These statutes are known as fraudulent transfers or voidable transactions laws. Generally, a potential creditor must only prove this by a “preponderance of the evidence,” which asks whether it was “more likely than not” that the transfer was a fraudulent conveyance. In Nevada, however, the potential creditor not only is given less time to bring a claim forward, but there also would be a heightened burden of proof required, called “clear and convincing evidence,” that the transfer was made in contravention of the law. This is a very high legal standard and can be difficult for a creditor to prove. Despite this,  a client should be cautioned to not to place all their assets into a DAPT. By leaving enough assets outside of the DAPT, there can be no argument that the client intended to remain insolvent. 
  • No exception creditors – The majority of DAPT states do allow for one or more exception creditors that can pierce through the trust even when a regular creditor can not. The most common exception creditors are divorcing spouse, alimony, or child support creditors. Some DAPT states also allow pre-existing tort creditors (e.g., medical malpractice) as exception creditors. Nevada and Utah do not allow for any exception creditors.
  • Ease of Use – In some DAPT jurisdictions, the grantor is required to sign a new affidavit of solvency each time they are transferring assets to their DAPT. An affidavit of solvency requires the grantor to attest each time that they remain solvent after transferring assets to the trust so that they are not attempting to “hinder, defraud, or delay” any creditor. For those who frequently transfer assets into their DAPT on a monthly basis, this requirement is not user-friendly as such affidavits must only be notarized. Again, Nevada does not require that such an affidavit be created each and every time.
  • Flexibility – The grantor of a Nevada DAPT retains many powers that otherwise would not be permitted in other situations. For instance, a grantor of a Nevada DAPT can act as the investment trustee of the trust. This allows the grantor to manage the investments inside the trust without giving up total control of the assets to a third-party. Furthermore, the grantor retains the right to hire and fire the trustees of the trust (e.g., distribution trustee and/or administrative trustee). If the DAPT is designed as an incomplete gift in Nevada, then the grantor may also retain the power to veto any distributions to the beneficiaries and to hold lifetime and testamentary limited powers of appointment, effectively allowing the grantor to re-name the beneficiaries of the trust at any point.
  • Protection for partnerships and LLCs – LLCs offer incredible asset protection of external assets (personal assets) against inside liability related to the LLC, but the question becomes whether there is any protection of internal assets of the LLC against outside liability like a car accident? In situations where a creditor obtains a judgment against an LLC member, the creditor can petition the court to foreclose the interests of the LLC member where, if granted, the creditor can then obtain the assets within the LLC.  In Nevada, foreclosing the interest of an LLC member is not permitted, and a creditor may only obtain what is called a “charging order.” A charging order is basically a lien over any economic interest, whereby the creditor waits in line essentially until there is a liquidation or distribution event of the member’s interest in the LLC. A holder of a charging order cannot force a distribution though, and cannot participate in any management of the LLC, or the investments of any of its assets.  Nevada has no other remedies available to a creditor, including reverse veil piercing, constructive trusts, resulting trusts, or alter ego theories. 

The Ideal Candidate

An asset protection trust is not right for everyone but is especially common among those who work in careers that have greater liability risks, including doctors, real estate developers, business owners, and dentists. While there is no fixed minimum that is required to fund the trust, it is usually recommended for those individuals who are placing at least $1 million in assets. 

You do not need to be a resident of the DAPT state in order to take advantage of a DAPT. Still, it is important to note that if you live in a non-DAPT jurisdiction, there is a choice of law that the judge must decide between. In other words, if a California resident set up a Nevada DAPT but got sued in California, a California judge will need to determine which state law to exercise: California or Nevada? 

There are two ways to interpret this. First, some people read this to mean that because there is no guarantee that a judge will exercise Nevada law, there is no benefit in creating a DAPT if you live in a non-DAPT state. The other way to read this information is that because there is some uncertainty, this is perfect fodder for settling any lawsuit brought forward by a potential creditor, because the creditor themself is taking a risk. If the judge exercises Nevada law, the creditor may end up with nothing. Again, the ideal strategy is to shift any settlement discussion in your favor and having a DAPT allows for that, whereas not having a DAPT offers absolutely no asset protection.

Do it while the Sun is Shining

First of all, timing matters. Just as you cannot buy life insurance after you have died, and just as you cannot buy home insurance while your house has caught fire, you cannot protect your assets after a claim has been filed. John F. Kennedy said very poignantly, “The best time to repair the roof is when the sun is shining.” Similarly, asset protection trusts need to be created when you need it the least. If you wait until after an injury has occurred, it is too late generally. 

A DAPT is best used as a preemptive strategy and should be set up when there are no known or pending creditors. If a car accident has already occured, even if a lawsuit has not been filed, it may already be too late.  

Secondly, an asset protection trust like a DAPT should be treated as a rainy-day fund and, therefore, distributions from the trust should be occasional and limited. The strategy is not one in which distributions are to be made regularly from the trust to the beneficiaries.

The Hybrid DAPT

Perhaps a more superior alternative to a DAPT is a trust known as the hybrid-DAPT.

A hybrid-DAPT is a third-party irrevocable trust that has the exact same features as the DAPT with one notable difference. In the hybrid-DAPT, unlike the DAPT, the grantor is not listed as a permissible beneficiary. Instead, by avoiding having to name the grantor as a beneficiary, there is no room for a creditor to even pursue a claim against the grantor, since the grantor has no beneficial rights to the trust.

How then does the grantor ever access the assets in the trust? First, using Nevada law, the grantor may still serve as the investment trustee of the trust. Second, the grantor may also retain the power to hire and fire the trustees of the trust (e.g., distribution trustee and/or administrative trustee). Third, if the hybrid-DAPT is an incomplete gift, the grantor may also retain the power to veto any distributions to the beneficiaries and to hold lifetime and testamentary limited powers of appointment. 

Who would the beneficiaries be then if not the grantor? Many times, it can be family members such as spouses and children. If the grantor’s spouse is listed as a beneficiary, the grantor can maintain their lifestyle through distributions to the spouse. Moreover, in the unlikely event that all the beneficiaries predecease the grantor, the grantor may ultimately choose to use a trust protector who has the ability at a later date to add additional beneficiaries into the trust like the grantor.

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