United States Asset Protection in the 21st Century

The United States is a country of extremes – and asset protection is no exception. In the 21st century there are three trends that will shape protection planning – firstly, expanding attacks by the courts and the IRS, secondly, further proliferation of domestic asset protection opportunities (eg, state legislation seeking to create asset protection regimes), and thirdly, more exotic offshore protection opportunities.

The US Supreme Court had endorsed the vitality of asset protection arrangements. In the Grupo Mexicano case Supreme Court Justice Ginsberg commenting on international asset protection stated:

“...moreover, increasingly sophisticated foreign – haven judgment proofi ng strategies, coupled with technology that permits the nearly instantaneous transfer of assets abroad, suggest that defendants may succeed in avoiding meritorious claims in ways unimaginable before ....”

Several states have enacted asset protection trust legislation with the express intent of shielding debtors from creditor claims. Other states are likely to enact similar types of legislation – hence changing the ‘public policy’ of asset protection in the United States.

Some had predicted that the Anderson case was the death blow to asset protection. It is clear that asset protection is on the rise, not the decline. Many states, even those that have not been successful in circumscribing the ‘run away plaintiff ’s litigation,’ have determined that there is a benefit to legislatively providing protection from litigation.

Fundamentals of asset protection

Traditionally there are four core elements to asset protection strategies:

1 The use of Federal and state ‘exemptions’ from creditor claims (eg, pension plans and unlimited homesteads – Florida and Texas, Iowa, Kansas and South Dakota).

2 Contractual provisions that limit liability. Often the principal course of future liability comes from ‘clients’ – where liability can be limited, for example physicians and their patients. Contractual provisions that should be reviewed include: outright limitations on liability, mandatory mediation/ arbitration clauses, choice of law and choice of forum provisions, shortening the statute of limitations and claims period, jury waivers, etc.

3 The use of domestic and ‘offshore’ legal entities to provide a shield from claims, and to bar a creditor’s access to assets held in a legal entity (the assets of a LLCwith one member, where the LLC is ‘transparent’ for tax purposes, are not subject to the member’s creditor’s claims– even if the creditor is the IRS).

4 The use of the common law trust as both an estate planning and asset protection vehicle (‘integrated estate and asset protection planning’). ‘Selfsettled’ spendthrift trusts – which is at the core of asset protection requiring the settlor to completely transfer assets to an independent trustee – have been effective. Originally these types of ‘selfsettled’ trusts were only permitted ‘offshore’ but more recently a number of states have enacted asset protection trusts legislation.

The limitations

There are also substantial limitations on asset protection. In some states protecting your assets from a creditor claim may constitute criminal conduct, and any action taken to hinder or delay the payment of sum to the government is a criminal act.

Fraudulent conveyance (transfer) statutes allow the court to unwind a transaction,and impose liability on persons involved in transfers that leave a debtor or potential debtor without adequate assets to meet creditor claims.

For most structures based upon an entity or trust, traditional challenges to pierce the structure have been successful in attacking structures perceived to be abusive, e g, sham, alter ego, constructive trust, nominee and agency.

The 2005 amendment to the bankruptcy law limits benefits of ‘selfsettled’ trusts, and moving to another state to qualify for exemptions (eg homestead), you have to have lived in the state for 1,215 days (3.3 years), but the state exemptions will not apply if the filing was ‘abusive’ (it is too early to determine what will be considered ‘abusive’), or the claim is a result of securities fraud, civil RICO or liability from a violent crime – in which case the bankruptcy homestead limitation of US$125,000 applies.

US constitutional principles available to creditors such as the requirement that judgments from one state be recognised by all other states, may limit the benefit of many of the so-called domestic asset protection trust structures.

Courts and IRS

For years the IRS has cast a suspicious eye on asset protection because there is a notion that most offshore asset protection structures involve some type of tax evasion, and also because a structure that hinders or delays collection of tax is a crime.

Since the late 1990s there are substantial reporting obligations regarding a ‘foreign trust’, both at establishment and annually. The penalties for failing to report can be staggering – if none of the required reports are filed in as few as five years the entire principal of the trust can be wiped out with accrued taxes, interest and penalties.

It is a crime to engage in any type of planning to hinder or delay the payment of any federal (or state) obligation, including any action intended to shield assets from tax collection. It is a crime to assist someone who is shielding assets from the tax collection process. Any person or advisor who is involved in asset protection relating to tax may face both civil and criminal liability. It is clear that the IRS will be more aggressive in seeking criminal sanctions against anyone involved in tax-protection activities. But all is not lost – certain structures, put in place prior to incurring tax liability may offer some insulation (eg, a pre-nuptial agreement can protect the innocent spouse, however, homestead and tenancy by the entirety will not be effective).

If an asset protection structure is established for a valid purpose (ie, unrelated to tax) and is properly reported to the IRS, it should not be subject to challenge by the IRS. But any structure, and in particular any offshore structure, may well attract the IRS’ attention.

The Bankruptcy Act 2005 has made it more difficult to integrate bankruptcy and asset protection, but opportunities still exist.

Asset protection structuring falls into one of two modes – reliance on state exemption from creditor claims, eg homestead, or giving up ownership over the assets, in exchange for some limited rights (eg, an income stream).

Structures that faithfully follow the statutory exemption route have proven to be almost iron-clad. For example, in Havaco v Hill, Hill lost the trial, and just before the judgment was entered he moved o Florida and claimed the unlimited homestead. The Florida Supreme Court held that Hill’s home was protected against Havaco even though Hill moved to Florida solely to protect the equity he had invested in the Florida home.

As to ‘divesting’ arrangements, in the past decade there have been no novel or unique attacks on asset protection structures. No new techniques have been needed and the traditional methods have been adequate. In most instances the client does not follow the conservative advice of counsel and maintain distance from the assets the client has told creditors and the courts they no longer have control over.

With good instructions from counsel, faithfully followed by the client and with timely implementation, most asset protection structures will achieve a degree of success.

 Expanding domestic asset protection structure

When one thinks of asset protection they often envision exotic offshore locations and complex structures. Yet asset protection via entities dates from the first incorporated enterprise in America in the late 1780s. However, express statutory limitation of liability of individuals dates from April 1997 when Alaska enacted asset protection trust legislation.

Case law in the US for more than 150 years has recognised a 'spendthrift' provision in a trust - that is a bar on a creditor from reaching the beneficiary's interest in the trust. For more than 100 years case law has also recognised that it is against US public policy for a person to establish a spendthrift trust to benefit themselves - the so-called 'self-settled spendthrift trust'. However, the Cook Islands was the first jurisdiction to enact 'designer' legislation authorising the establishment of self-settled trusts.

 Alaska enacted the legislation as a way to attract business and assets. Its law focused on the requirement that an Alaskan asset protection trust required inter alia two things - a trustee based in Alaska, and some of the assets had to be maintained in Alaska. Nevada enacted its statute in part to protect physicians who were leaving the state due to the high cost of medical malpractice insurance.

Today, the following states have asset protection legislation, allowing for selfsettled trusts: Alaska, Colorado, Delaware, Missouri, Nevada, Rhode Island and Utah. Bills have been recently introduced in several other states (see the table on 20).

Offshore protection is still king

Notwithstanding the expanding domestic opportunities, between the aggressiveness of American courts being 'outcome driven' to find ways to invalidate a protective structure that the court finds offensive (eg the settlor continued to 'control' the assets after allegedly 'transferring them') combined with nation-wide enforcement of judgments (either through the federal courts or enforcement of sister state judgments), no domestic structure will be as effective as a well and timely established offshore structure.

Trusts have been the traditionally favoured structure for asset protection. Starting with the Cook Islands and now numbering in excess of 20, offshore jurisdictions have enacted specialised trust law that provide for asset protection. The specialised laws include the elimination of 'fraudulent transfer' rules, or shortening the statute of limitation to bring an action, ignoring 'non-local' judgment, require the posting of a bond. None of the 'domestic' laws provide the degree of protection that the offshore legislation does.

None of the offshore asset protection jurisdictions will give credence to a 'foreign judgment', and will require the full claim against a trust or its beneficiary be tried in their country. It is often not practical for a creditor to first sue a defendant in a US court, only to have to file another action in a foreign court. In addition, some of the asset protection jurisdictions require that the settlor and beneficiary be a party to any litigation. But the law in those countries can only obtain 'jurisdiction' over a person who is physically present in that country. Hence it is often impossible for a creditor to obtain jurisdiction over the settlor and the beneficiary, thus leaving the creditor without effective remedy in the country of formation of the trust. On the other hand, a judgment rendered in California finding an Alaskan trust a sham will be effective in Alaska - because under the US constitution one state must give full-faith and credit to a sister state's judgment.

In the Cook Islands nothing is static - once the king of asset protection the Cooks Islands is starting to lose its sheen. The Cooks were the first of the offshore jurisdictions to create laws specifically intended to establish an asset protection regime. Initially the Cook Islands courts were not receptive to the notion of asset protection, as evidenced by the Orange Grove case, where the court said that the legislature did not really mean what the legislation said.

In the Anderson case the Cook Islands stood strong against the challenges of the Federal Trade Commission attacks - and ultimately that litigation was favorably settled, at least from the trust's perspective. More recently political instability in the Cook Islands has raised concerns among some (eg, claims by two groups to be the government).

Trusts are creatures of common law countries, those whose legal systems flow from English law. Most of the world follows civil law that is based upon continental European law. A number of jurisdictions have now created a specialised version of the Liechtenstein stiftung or a 'foundation' - essentially a hybrid between a trust and a corporation, combining the more favourable aspects of each. For example, Panama's example Article No. 11 provides: "The assets of the foundation shall constitute an estate separate from the founder's personal assets for all legal purposes, and may not be seized or attached... In no case shall such assets be affected or used to respond for the personal obligations of the founders or of the beneficiaries."

Civil law jurisdictions are more likely to respect an asset protection foundation. Civil law judges strictly follow the word of the statute - and there are no juries. As long as the foundation files its required forms there is a great likelihood that the entity will be respected, unlike common law jurisdictions that look at the 'poor debtor' and strive to find a way to ignore or pierce the asset protection trust.

In the future, we are likely to see great use of foundations for asset protection, and less use of trusts.

In conclusion...

The future for asset protection for nongovernmental creditors is very rosy, and expanding. We envision the two primary areas of growth will come from re-focusing on risk management techniques that seek through best practices to prevent the liability from arising, and if it does arise, through the use of contractual provisions limiting the potential magnitude of liability.

Second, we will see a shift from the offshore asset protection trust, to asset protection trust foundations created in civil law jurisdictions. Only after a decade or more of litigation over the 'domestic' asset protection trust will a cautious practitioner consider employing such a vehicle for anyone other than a resident of the state whose business is conducted in that state.

With an overly litigious society and welcoming courts, Ben Franklin's old expression should now be modified - 'Nothing is certain but death, taxes, being sued, and that the wise will protect their assets.' n

1 Mr Fisher is a member of the California Bar, and the Honourable Society of Lincoln's Inn (London [student bencher]). Mr Fisher is a graduate of the University of Southern California (BA), Southwestern University (JD), and the University of Cambridge (LLB with honours).

2 Denis A Kleinfeld is based in the American Virgin Islands, with offices in Miami, Florida. He is a graduate of the University of Illinois (BS in Accountancy, 1967) and is a Certified Public Accountant. He received his JD from Loyola University of Chicago.

3 Mr Fisher is a graduate of the University Of Michigan (BA - Econ/Comm 2004), and is presently in his third year at Emory University School of Law.