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 Situation

The debtor, an Alaska resident,  established an Alaska self-settled trust and transferred real property into it. The trust expressly stated its purpose as protecting assets from creditors.

The trust was funded with Alaska real property and other assets; trustees and the protector were family members or close associates.

The debtor later filed for Chapter 7 bankruptcy within ten years of funding the trust.

At the time of transfer, he was solvent, and the transfer fell outside Alaska’s four-year statute of limitations for fraudulent transfers under state law.

Key Legal and Factual Issues

• Bankruptcy avoidance: Whether transfers to the self-settled trust were avoidable under 11 U.S.C. § 548(e) (ten-year lookback for transfers to self-settled trusts with actual intent to hinder, delay, or defraud).
• Effect of state DAPT statute: Whether Alaska’s DAPT protections and solvency affidavit insulated the trust from federal bankruptcy avoidance.
• Intent: Whether the trust’s stated purpose evidenced actual intent.

The Outcome

The structure failed in bankruptcy.

The court held the transfers avoidable under 11 U.S.C. § 548(e) and brought the assets back into the bankruptcy estate. 11 U.S.C. § 548(e) is a federal provision allowing avoidance of self-settled trust transfers made within ten years if made with actual intent to hinder, delay, or defraud creditors. The court emphasized that Congress enacted § 548(e) specifically to address asset-protection trusts, and found the requisite intent present.
The court stated that “Congress has expressed a clear intent to reach self-settled trusts such as the Trust at issue here.”

The Key Lesson

Battley highlights that: 

• Bankruptcy is a structural stress test that DAPTs often fail, particularly within the ten-year § 548(e) window.
• Purpose language matters: Drafting that emphasises creditor defeat can be fatal in litigation.
• Family-controlled governance increases risk: Trustees and protectors lacking independence undermine defensibility.
• Trustees and advisors must treat self-settled domestic trusts as high-risk where insolvency or bankruptcy is foreseeable.

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)

The Situation

The debtor, a Washington real estate developer, created an Alaska domestic asset protection trust (DAPT) in 2008 while experiencing severe financial distress tied to the collapsing housing market. The trust named an Alaska trust company and the debtor’s son as trustees and contained an Alaska choice-of-law clause. 

He transferred cash and securities into the trust and later transferred additional Washington-based assets. Ultimately, approximately 78% of the debtor’s net worth—largely Washington-based assets—was transferred into the trust. The debtor remained a discretionary beneficiary and continued to live in trust-held property and receive substantial financial support from the trust. 

At the time of settlement, the debtor faced known and escalating creditor claims arising from real estate guarantees. The debtor filed for bankruptcy in Washington in 2011.

Key Legal and Factual Issues

• Choice of law: Whether Alaska law (per the trust deed) or Washington law governed creditor rights.
• Fraudulent transfer: Whether the funding of the trust was avoidable under Washington’s Uniform Fraudulent Transfer Act (UFTA).
• Settlor benefit and intent: Whether continued enjoyment of trust assets supported an inference of intent to hinder or delay creditors.

The Outcome

The structure failed entirely as an asset protection mechanism.

The bankruptcy court declined to apply Alaska law. The court applied Washington law, not Alaska law, and held the transfers fraudulent and avoidable

Applying Restatement (Second) of Conflict of Laws § 270, the court held Washington had the “most significant relationship” to the trust. The court emphasized that the settlor, beneficiaries, and most assets were in Washington, stating that Alaska’s only meaningful connection was that it was “the location in which the trust was to be administered and the location of one of the trustees.”

Substance over form: The debtor’s continued residence in trust property and receipt of trust-funded support showed that the trust did not alter the debtor’s economic reality.

Actual intent inferred: Multiple badges of fraud were present, including the magnitude of transfers, timing in the face of known claims, lack of consideration, and retained benefit.

No need for a sham finding: The court did not need to declare the trust a sham; fraudulent transfer law was sufficient to unwind it.

Because Washington has a strong public policy against self-settled spendthrift trusts, the transfers were avoidable and the trust assets became available to creditors.

The Key Lesson

Huber demonstrates a core weakness of DAPTs: they are vulnerable to forum-state public policy overrides. 

Governing-law clauses are fragile where the settlor, assets, and administration are concentrated in a non-AP forum.

Retained benefit is a vulnerability; ongoing enjoyment of trust assets is often dispositive.

Timing matters: Funding an APT in the face of known liabilities invites avoidance.

Trustees should conduct and document robust solvency and creditor-risk analysis at settlement and resist structures that rely on jurisdictional arbitrage rather than genuine separation.

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.