The Downsides of Domestic Asset Protection Trusts

Introduction

Domestic Asset Protection Trusts (DAPTs) are often considered a cost-effective alternative to Offshore Asset Protection Trusts (OAPTs). However, a detailed examination reveals that DAPTs have significant legal vulnerabilities that undermine their effectiveness compared to offshore options. This article explores the limitations of DAPTs, highlighting key legal precedents and ongoing issues.

Summary

Due to its moderate growth, the DAPT has been seriously considered by high-net-worth individuals in the States. On its face, the DAPT appears to be a cheaper and better alternative to an OAPT, and there is no shortage of lawyers overstating their benefits. However, while a DAPT can certainly be cheaper to establish and maintain, that discount may prove to be more costly in the end for clients seeking absolute protection for their wealth.

Legal precedent has established that there are several principal concerns lawyers should understand before advising clients on implementing a DAPT: 1) conflict of law rules; 2) constitutional issues; and 3) statutory exceptions. OAPTs contain none of these shortcomings, since they are removed from the jurisdiction of U.S. courts, which is why they are a superior asset protection tool.

Cost Considerations

For clients, the cost to establish and maintain a trust can be a major factor in determining whether to use a domestic or foreign trust. While providing a precise figure depends on the client’s facts and circumstances, OAPTs are generally more expensive than DAPTs to both implement and to maintain annually. However, given the level of wealth generally involved when clients are considering asset protection trusts, the cost differential on a relative basis is negligible.

Any increase in price and additional regulatory requirements for OAPTs are justified by the higher level of protection they provide. OAPTs create a strong deterrent effect, or at worse, an inducement for creditors to settle early and for favorably low amounts. OAPTs accomplish this by erecting barriers that make litigation for the creditor expensive, time consuming, and highly unlikely to succeed.

OAPTs are also governed internally by their contract provisions and are governed externally by the laws of the situs jurisdiction, which are generally very debtor friendly, and more stringent than similar U.S. laws. Perhaps more significantly, as outlined in the case law below, OAPTs are not subject to the laws of the U.S., which means they can disregard judgments, and lawyers, from U.S. jurisdictions. This alone makes OAPTs a stronger and more reliable asset protection tool.

• DAPTs: Typically less expensive to establish and maintain. However, this lower cost can be misleading as the potential legal challenges and limitations might result in higher costs over time.
• OAPTs: More expensive to set up and maintain but offer superior protection. These trusts are governed by laws of jurisdictions that are more favorable to debtors and are insulated from U.S. judgments, providing a higher level of asset protection.

Unfavorable Legal Precedent

Because DAPTs have existed in the U.S. for a number of years, courts have had numerous opportunities to test the waters regarding their effectiveness. Unfortunately, the legal precedent surrounding DAPTs is weak and has created more questions than answers.

Several significant cases illustrate the weaknesses of DAPTs:

• Battley v. Mortensen (2011): The court voided a settlor’s transfer of property to an Alaska self-settled asset protection trust, deeming the transfer as a fraudulent conveyance. The settlor was solvent when he transferred the property and was also beyond Alaska’s four-year statute of limitations for transfers to a DAPT. However, in this case, the court applied federal Bankruptcy law, which has a ten-year statute of limitations. Consequently, the DAPT was penetrated, and the assets in the DAPT were fair game to creditors. Thus, where federal bankruptcy law is applicable, the result in Mortensen is essentially that DAPTs will not protect assets from creditors for the first ten years after the trust is settled.

Summary: The court voided the transfer of property to an Alaska DAPT as a fraudulent conveyance under federal bankruptcy law, demonstrating the vulnerability of DAPTs to federal statutes, particularly within the first ten years of their creation.

• Kilker v. Stillman (2012): The settlor, a California resident and soil engineer, created a self-settled Nevada DAPT funded with virtually all of his assets because “soil engineers are frequently sued.” At the time the DAPT was created, the settlor had no knowledge of any legal issues or claims. About four years after the DAPT was created, homeowners sued the settlor for alleged damages that occurred as a result of the settlor’s soil testing in 2000. A judgment was ultimately entered against the settlor in favor of the homeowners. In order to enforce the judgment, the homeowners sought to invalidate the creation and funding of the DAPT on the basis that the transfer of property to the DAPT in 2004 was a fraudulent transfer. The court noted that even though the homeowners were not known current creditors at the time of the transfer, the event giving rise to the liability had occurred in 2000 prior to the 2004 transfer. As a result, the court held that the transfer was a fraudulent transfer since it was made to “hinder, delay or defraud any creditor,” including a future creditor. The court finally found that, while the DAPT may be valid under Nevada law, the transfers to the DAPT were fraudulent transfers and invalid as to all creditors.

Summary: The court invalidated a Nevada DAPT as a fraudulent transfer because the event causing liability occurred before the trust’s creation, showing that future creditors can challenge DAPT transfers.

• In re Huber (2013): This case addressed a choice of law issue. The settlor, a Washington real estate developer, created a DAPT in Alaska in 2008 at a time when the real estate market was crashing. The DAPT was funded with cash located in Alaska, with the rest of the assets being located in Washington. The settlor’s son, along with an Alaska trust company, served as trustees. The settlor filed for bankruptcy in 2011. The bankruptcy court in 2013 applied Washington law and ruled that the Alaska DAPT did not prevent access by creditors, noting that the DAPT was created when the real estate market was crashing, which opened the issue of a fraudulent conveyance. The court further held that the laws of the state selected by the settlor will apply so long as that state’s law does not violate a strong public policy of the state with which the DAPT has its most significant relationship. The court found that the DAPT had its most significant relationship with Washington since the settlor, beneficiaries, and most of the assets were located in Washington, and the only relation to Alaska “was that it was the location in which the trust was to be administered and the location of one of the trustees.” The court went on to note that Washington has a strong public policy against self-settled asset protection trusts.

Summary: The court applied Washington law over Alaska’s, invalidating a DAPT based on the state’s public policy against self-settled trusts, emphasizing that the law of the state with the most significant relationship to the trust will prevail.

• Dahl v. Dahl (2015): This case involves a divorce proceeding in Utah between Dr. Dahl and Mrs. Dahl. Four years before the divorce, Dr. Dahl established a self-settled Nevada DAPT, to which he then transferred marital assets into the DAPT. When the Dahls filed for divorce in Utah years later, the trial result was that the DAPT was excluded from the marital estate. However, on appeal, the Supreme Court of Utah found that the DAPT should have been included as part of the divorce proceedings, despite the fact that the trust named Nevada as the domicile in its choice of law provision. The court determined that Utah has a strong public policy interest in the equitable division of marital assets and that Utah law should apply even though Nevada was listed in the choice of law provision.

Summary: Utah’s Supreme Court ruled that a Nevada DAPT should be included in divorce proceedings, highlighting that state public policy interests can override the choice of law in trust documents.

• Toni 1 Trust v. Wacker (2018): The Supreme Court of Alaska ruled against an Alaska statute that granted Alaska exclusive jurisdiction over fraudulent transfer actions against an Alaska trust. The case involves Montana residents that were tied up in litigation, and in the midst of a judgment being rendered in favor of the plaintiff, the defendant created a self-settled DAPT sitused in Alaska and transferred most of their assets to the trust. The plaintiff filed an action in Montana, alleging that the transfer to the DAPT was fraudulent under Montana law. A default judgment was entered against the defendant in Montana; however, the defendant filed for bankruptcy in Alaska, making their interest in the property of the DAPT subject to the jurisdiction of the federal bankruptcy court. Along with the Montana state court, the federal bankruptcy court also issued a default judgment against the defendant. The defendant requested that the Montana and federal bankruptcy court judgments be set aside as void because of an Alaska statute that stated that Alaska courts have exclusive jurisdiction over fraudulent conveyance claims involving Alaska DAPTs, and that under the Alaska statute, the statute of limitations had already run. Making reference to the Full Faith and Credit Clause and the Supremacy Clause, the court held that the Alaska statute cannot “prevent other state and federal courts from exercising subject matter jurisdiction over fraudulent transfer actions against [Alaskan DAPTs].” Thus, even if a settlor creates a trust in a DAPT-friendly state such as Alaska, the assets in the trust may still be accessible based on a judgment rendered in a different state. From an asset protection standpoint, this case establishes that clients cannot rely on the DAPT statute of another state, nor the trust document, to establish jurisdiction; in the end, the court will determine which law applies, and will respect the jurisdiction and judgments of the other U.S. states. It is in this respect that the Toni 1 Trust case follows both the Dahl and Huber cases in its disregard for the stated jurisdiction of the DAPT.

Summary: The Alaska Supreme Court ruled that Alaska’s jurisdictional statute over DAPTs cannot prevent other states or federal courts from exercising their jurisdiction, underscoring the limits of DAPT statutes in shielding assets across state lines.

• De Prins v. Michaeles (2018): The Massachusetts Supreme Court ruled that a creditor could reach the assets of a spendthrift irrevocable trust governed by Massachusetts law. The case involves a former Massachusetts resident/settlor who committed a double murder in Arizona and committed suicide the next day. Prior to the murder, the settlor created a self-settled, irrevocable spendthrift trust for his sole lifetime benefit, permitting unlimited distributions to himself during his lifetime. The issue presented was whether the creditor – the surviving child of the murdered couple – could collect a wrongful death settlement against the settlor’s irrevocable trust. The court held that the creditor could reach the assets on multiple grounds. The court found that regardless of a spendthrift provision, a creditor can reach the maximum amount of the trust that can be distributed to or for the settlor’s benefit. The court reasoned that since the entire trust could have been reached by the settlor during his lifetime, the trust was subject to attachment. There was also a post-mortem trust attachment issue, and the court held that Massachusetts common law holds a self-settled irrevocable trust for the settlor’s own benefit fully subject to the claims of his creditors.

Summary: The Massachusetts Supreme Court allowed a creditor to reach assets in a spendthrift trust, reaffirming that self-settled trusts, even if irrevocable, are subject to creditor claims if the settlor retains significant benefits.

Areas of Continuing Vulnerability for DAPTs

• Conflict of Laws: Deciding which state’s law should apply is not always a straightforward analysis, especially when a case involves a fact pattern where the conduct, parties, and assets are in different states. For example, if all the parties were from Nevada (a DAPT-friendly state), the cause of action arose in Nevada, and all the trust assets were located in a Nevada DAPT, then it is likely that the laws governing Nevada DAPTs will govern since there is no conflict. But in practice, the facts are rarely this straightforward. A more common scenario might look more like the Huber case, where the settlor is from Washington, a co-trustee is in Alaska, and the assets are located in both Washington and an Alaskan DAPT with an Alaska choice of law provision. When this type of diversity is present, the courts must balance the states’ interests when determining which state’s law to apply. Even if most of the elements fall within one state, a court may still decide to apply the laws of another state. Unfortunately, this is an issue left to the discretion of the court. When a court is faced with a conflict of laws issue, the validity of the DAPT may completely depend on where the court believes the DAPT has the most significant relationship. This is generally unfavorable for clients, because many people create DAPTs in states separate from where they are domiciled, and the cause of action giving rise to the liability rarely occurs in the state in which the DAPT exists. This was the case in Huber, and there the court disregarded the DAPT because the only relation to Alaska was that it was the location of the DAPT. Based on the case law to date, it appears that the DAPT state is the least likely.
• Constitutional Issues: The fact that states must recognize and enforce judgments rendered by the courts of other states creates a huge loophole in the enforcement of DAPTs. Article IV of the U.S. Constitution provides that all U.S. state courts must give “full faith and credit” to the judgments of other state courts of competent jurisdiction. Where this becomes problematic is when the DAPT is formed under the law of a given DAPT state, but either one of its trustees or the settlor resides outside the DAPT state, or some of its assets are outside the DAPT state, or the trust conducts business outside the DAPT state. In this scenario, as demonstrated in the Toni 1 Trust case, the DAPT may be vulnerable to a non-DAPT state court judgment under the Full Faith and Credit Clause. It is also worth noting that the Supremacy Clause presents a similar issue. Article VI, Clause 2, of the U.S. Constitution provides that the Constitution, and the laws of the United States, are the supreme law of the land. Thus, if a U.S. Bankruptcy Court renders a judgment against a settlor under the federal Bankruptcy Code rules, the Supremacy Clause may come into play so that federal law, or the law of the settlor’s domicile, but not that of the DAPT, will be determinative of the issue of whether creditors can reach assets in the DAPT. This was also the case in Toni 1 Trust, where U.S. Bankruptcy Code Section 548(e)8 overrode the Alaska state law exemption. By analyzing the Toni 1 Trust case and the constitutional issues surrounding DAPTs, it seems that DAPT legislation apparently only protects trusts settled by actual residents of the DAPT state in question. However, this is not established
• Statutory Exceptions: Even if a court applies the laws of a DAPT jurisdiction, the exceptions to the DAPT statute may render the DAPT useless. Both OAPTs and DAPTs have exceptions for fraudulent transfers, but DAPTs take it a step further. Most DAPT statutes provide express exceptions to the statute’s spendthrift protection. For example, Delaware provides exceptions for debts related to child support, alimony, and property division claims.9 Delaware also provides a carve out for tort claims that arise as a result of death, personal injury or property damage occurring on or before the date of the transfer to the trust.10 Some states, such as Missouri and West Virginia, provide exceptions stating that a spendthrift provision is unenforceable against a claim to the extent a state statute or federal law so provides.11 Under this exception, a spendthrift provision may not be enough to prevent the attachment of a state or federal lien.

Statutory Exceptions

The following chart provides a quick comparison of common DAPT statutory exceptions:

These statutory exceptions mean that DAPTs in some states offer no protection against certain creditors even when there is no fraudulent transfer. The trusts are penetrable by their own terms. Additionally, these exceptions are not uniform across all DAPT states, creating further uncertainty in the effectiveness of DAPTs.

Conclusion

In the world of asset protection, lawyers must provide their clients with the greatest degree of certainty with respect to enforcement and level of protection. It is here where DAPTs have the greatest deficiency. The inconsistent case law paired with the constitutional and legislative issues make DAPTs an incredibly risky protection tool for the private client.

The truth is that unlike OAPTs, DAPTs are missing one crucial element: the ability to disregard the judgment of another jurisdiction. Because DAPTs are governed by U.S. law, they will always have vulnerabilities that are not present offshore.

Contact Us

For more information on how to best protect your assets and to explore whether a Cook Islands Trust or another Offshore Asset Protection Trust might be suitable for your needs, please contact Blake Harris Law. Our experienced team is here to provide personalized advice and solutions tailored to your specific situation.