What Local Advisors Need to Know About

Foreign Asset Protection Trusts

By Vernon K. Jacobs, CPA, CLU

Advantages of a Foreign Asset Protection Trust

The Trust Protector

Tax Rules for Foreign Trusts

Offshore Trust Jurisdictions

Appropriate Uses of a Foreign Asset Protection Trust

References

Web Site Resources

About the Author

Copyright, Vernon K. Jacobs, May, 2005. All rights reserved.

A Brief Introduction to Trusts

Definition of a Trust

A legal entity created by a grantor for the benefit of designated beneficiaries under the laws of the state and the valid trust instrument. (Black’s Law Dictionary) A trust is also described by some commentators as a relationship rather than an entity.  The grantor relies on the trustee to hold title to certain assets and to use the income, gains or assets for agreed upon care of the beneficiaries.

A Constructive Trust

A verbal trust based on common law rather than on a trust agreement and statutes. (Black’s Law Dictionary)

The Parties to a Trust

·         The trust grantor (also known as settlor).

·         The trustee or trustees

·         The trust beneficiaries

·         A trust protector (in connection with a foreign trust)

A Self Settled Trust

A trust where the grantor is one of the beneficiaries; sometimes also called a grantor trust.

Grantor Trust

A trust in which the settlor conveys property to a trustee to manage for the benefit of the settlor/grantor alone or for the benefit of the grantor and other beneficiaries. For U.S. tax purposes, a grantor trust is one where the trust settlor has retained sufficient rights and/or powers over trust distributions or trust management that the tax law deems the settlor to be the owner of the trust assets for tax purposes and therefore subject to tax on the income and gains of the trust. (IRC 671 – 678). A revocable living trust is a grantor trust.

A foreign situs trust with a living U.S. settlor and with one or more U.S. beneficiaries is classified as a grantor trust by IRC sections 673, 674, 676, 677 and  679. A foreign situs trust formed by will (testamentary) is not a grantor trust and a foreign trust formed by a non resident alien is not a grantor trust for U.S. tax purposes.

A Discretionary Trust

A trust where the trustee is given discretion regarding the investment of assets and distributions of income or principal to the trust beneficiaries. (Black’s Law Dictionary). Most foreign trusts give the trustee the discretion to make distributions to or on behalf of the trust grantor.

A Spendthrift Trust

A trust created to provide a fund for the maintenance of a beneficiary and at the same time to secure the fund against his improvidence or incapacity. .. (One where) trust provisions prohibit creditors from attaching (the assets of) a spendthrift trust. (Black’s Law Dictionary)  Note: Most foreign trusts are spendthrift trusts.

A Self Settled Spendthrift Trust (SSST)

A trust established to prevent creditors of the trust settlor from attaching the assets in the trust. Such trusts are contrary to the policy and laws of most states, but a few of the states have established such trusts by statute. A few of the states include Alaska, Delaware, Oklahoma (to the extent of one million dollars), Nevada, Missouri, Rhode Island South Dakota, and Utah.  Some people believe that Florida may soon pass legislation to authorize such trusts.

Domestic SSSTs/APT

For U.S. tax purposes, a domestic trust is one where (1) a court within the U.S. can exercise primary jurisdiction over the administration of the trust and (2) one or more U.S. persons has the authority to control all substantial decisions of the trust. The location of the assets in the trust, the country in which the trust was formed and the residence of the trustee are no longer part of the definition for tax purposes.

Foreign SSSTs/FAPT

For U.S. tax purposes a foreign trust is one that is not a domestic trust.

A variety of foreign jurisdictions have passed legislation to explicitly permit the establishment of a discretionary (self settled) spendthrift trust for the benefit of the trust settlor and other beneficiaries. Such jurisdictions include but are not limited to Anguilla, the Cook Islands, Bahamas, Gibralter, Nevis, Cayman Islands, Belize, Switzerland, Luxembourg, St. Lucia, St. Vincent and the Grenadines.  Note that an asset protection  trust jurisdiction is not necessarily a tax haven.

Why Venture Offshore?

Protection of Assets from Future Creditors

Individuals who have accumulated significant assets often become concerned when reading about some of the predatory litigation in the U.S.  Almost everyone with any substantial net worth has heard a litany of horror stories about predatory lawsuits. High on the list are medical doctors and other professionals who are at risk for malpractice suits.  Anyone who is an employer is also in a very high risk category for potential lawsuits. Parents of teenagers, owners of any real estate, drivers of motor vehicles or airplanes and owners of aggressive pet dogs are a greater risk of being sued than other persons. In addition, the mere accumulation of a significant net worth can serve as a magnet to legal predators. People in all of these groups often seek help to protect some of their assets from being taken in the event that they might end up on the losing side of a lawsuit. 

Because the foreign asset protection trust is deemed by many planners to be the most difficult for a plaintiff to penetrate, , it is the method of choice for many affluent individuals with a high risk exposure

Investment Opportunities

There are a few adventurous investors who believe that there are much better investment opportunities (such as many hedge funds) outside the U.S. than through the U.S. securities markets.  However, the U.S. Securities and Exchange Commission (SEC) prohibits any vendor of any security from offering an investment security to U.S. persons within the U.S. unless (1) such securities are registered, or (2) the securities are purchased outside the U.S.  In order for a U.S. investor to purchase foreign securities that are not registered with the SEC, the foreign vendors almost always require that the buyer be a non U.S. trust or corporation.  Thus, foreign investors may need to use a foreign trust solely for the purpose of being able to purchase any foreign securities.

Protection from US government

There are a some people who feel that the U.S. government is a greater risk to their life savings than any litigation. Due to a succession of laws beginning with the Bank Secrecy Act and culminating with the USA Patriot Act, the government can seize the assets of nearly anyone for many reasons under what are referred to as “forfeiture laws. Others are concerned about the prospect of future exchange controls that may prevent them from moving assets offshore, so they are doing that gradually while it is still legal.

Employment Opportunities

For many decades, U.S. multinational corporations have coerced some of their employees to work in foreign locations as a way to gain points in the quest for higher rungs on the management ladder of success. When U.S. employees move abroad, they often begin to do as the locals do and they buy foreign investments. After a while, someone will urge them to put the investments into a foreign trust (in a jurisdiction other than the one where they are working) to protect those investments from local inheritance or estate taxes and from corrupt local officials.

Business Opportunities

An increasing number of American entrepreneurs are venturing outside the U.S. to pursue business opportunities in developing economies like China and Russia or South America.  Rather than risk 100% of their assets, they often put a nest egg of savings and investments into a foreign trust that will be safe from the unknown laws and the political corruption in countries that are changing from a system of total autocracy to a system with some laws.

Personal or Family Reasons

Many people have immigrated to the U.S. in the past few decades but they have family in other countries with other kinds of laws. A foreign trust may be established for them by a parent or grandparent who is not a U.S. citizen or resident. Some people in other countries decide to immigrate to the U.S. or to take jobs in the U.S. for an extended period of time and they choose to put a large part of their net worth into a foreign trust before they move to the U.S.  Or, in some cases a U.S. person will set up a foreign trust for the benefit of relatives who are non-resident aliens.

Advantages of a Foreign Asset Protection Trust

It is enormously difficult for a U.S. judgment creditor to attach assets held by a foreign trust because the judgment creditor must often re-try the case in the country where the foreign trust is located. In most cases, the laws of those countries require the plaintiff to hire a local attorney. In some of those countries there are not a huge number of local attorneys waiting for a client. Some of these countries permit the attorney to work on a contingent fee basis. Most (if not all) of these countries require the plaintiff to pay the court costs and the legal fees of the attorney for the foreign trust if the plaintiff does not win the case.  Finally, many of the offshore jurisdictions require the plaintiff to bring the claim within a two year fraudulent conveyance statute of limitation period from the time the assets were transferred to the trust.  Regardless, of all of the other hurdles, the plaintiff will run into a brick wall if a claim is not be brought within the required time limits.

Increases the Cost of Litigation to the Plaintiff

The U.S. judgment creditor (plaintiff) must pay for the time and travel expenses of a U.S. attorney to travel to the jurisdiction of the foreign trust, to hire a local attorney and to try to convince a local court that the trustee of the foreign trust should relinquish the assets in the foreign trust.  In most of these asset havens, their trust laws serve to attract trust assets which provide employment for local professionals.  Their judges are therefore not overly sympathetic to the claims of a foreign plaintiff. It’s an entirely different situation than would occur in the U.S. and far more expensive to the judgment creditor/plaintiff.

Foreign Trusts Can Be Used In Place of Domestic Trusts

Almost any kind of planning or estate disposition that you can accomplish with a domestic trust can also be accomplished with a foreign trust. 

Foreign Trusts Are Not Subject to U.S. Tax after Death of Grantor

After the death of a U.S. grantor of a foreign trust, the trust becomes a nonresident alien for U.S. tax purposes. Trust beneficiaries are not subject to current taxation on foreign source income of the trust.  If the trust invests in U.S. securities, it will be treated as a nonresident alien and taxes will be withheld by the U.S. payor at the rate of 30% unless a treaty provides for a lower rate or unless the income is exempt for foreign investors.

However, a U.S. beneficiary will be subject to tax on receipt of distributions from the trust that constitute current or accumulated income of the trust.  The US beneficiary will be subject to a punitive tax at this time.  [i]

The Trust Protector

When a U.S. person considers the risk of placing a substantial amount of his or her net worth in the hands of a foreign trustee in a foreign jurisdiction, it usually results in a high level of anxiety.  In most cases, the foreign trustee will be a total stranger who has simply been recommended by a U.S. attorney or other advisor and the prospective trust grantor will have good reason to be cautious.  A number of U.S. persons who have put money into a foreign trust have been unable to get the foreign trustees to comply with the terms of the trust. In all of these cases, the U.S. grantor dealt with a promoter who had a relationship with the foreign trustee and the two would consume the assets in the trust through exorbitant fees and expenses.

Trust Protector Oversees the Trustee

A trust protector can be utilized to ensure that the trustee is acting in accordance with the trust indenture, to prohibit distributions that would be adverse to the beneficiaries, to move the trust domicile if necessary and to replace the trustee if necessary. However, the duties of the protector should not include any actions that would make the protector a de-facto trustee.  The trust protector should be an institution outside the US and the trust location and should not have a U.S. branch office.

Trust Protector Can Replace the Trustee or Move the Trust Domicile

The powers of a trust protector are set forth in the trust agreement. In most foreign trust agreements, the trust protector is empowered to replace the trustee if the trustee is acting (or failing to act) in a manner that is detrimental to the beneficiaries – including the trust grantor.  However, the protector should be prohibited from becoming the trustee after removing a trustee. Usually, the protector is authorized to replace a trustee with one of a select number of identified foreign trust institutions rather than with an individual trustee.  In the event of a change in the political climate of the trust jurisdiction, the trust protector can often change the venue/location of the trust even if the trustee is retained. 

Duties Should Be Limited to Veto Powers

The protector should not be able to direct the trustee to take a specific action with respect to the management of the investments or the distribution of income or corpus. Nor should the protector be able to sign checks or engage in any of the normal duties of a trustee.  The powers of the trust protector should be limited to veto powers or the power to move the trust jurisdiction or to replace the trustee with an institutional trustee in a foreign jurisdiction.  Excessive authority over the trustee or the trust assets could make the protector a co-trustee.   

The Protector Should not be a Trust Grantor, Spouse or Beneficiary

If a trust grantor, a beneficiary or a person closely related to them can control the trustee in the role of a trust protector, questions can arise as whether the settlor has retained “dominion and control” over the trust, with the result that a U.S. court may find the settlor retained the power to repatriate the assets (An observation by the Judge in Anderson)..

Funding Choices

U.S. FLP or LLC Owned by Foreign Trust (the “Financial Fortress”)

Family limited partnerships (FLP) were promoted as asset protection devices in the U.S. years before the foreign trust became known to all but a very few wealthy people.  Some asset protection planners believe a U.S. FLP can be an  effective means of protecting investment assets from future creditors. However, a FLP must have at least one general partner who is liable for the acts of the partnership. In addition, in an article in the Journal of Passthrough Entities, Mark Merric, et al, gave the domestic FLP a relatively low rating as an asset protection device.

In 1977, Wyoming passed the first limited liability company (LLC) statute which effectively eliminates the need for a general partner to bear the risk of liability. Since then the LLC legal form has been adopted in every state. It is expressly designed to protect the assets of the LLC from being taken by the creditors of any member of the LLC and in almost all states, it provides the same charging order protection found in the Revised Uniform Partnership Act of 1976, which in this area was adopted by most states.

For many people, the U.S. FLP and LLC offer an attractive way to retain control over the assets in a foreign trust by simply putting the assets into the U.S. FLP or LLC and then transferring the shares of the FLP/LLC to the foreign trust. In theory, the foreign trust owns the entity that owns the assets and such assets should be protected from creditors. Some promoters have referred to this arrangement as a “Financial Fortress”. However, critics of this approach argue that the U.S. courts have jurisdiction over the FLP or LLC and can invent ways to freeze the assets until the court can find a way to penetrate the legal barriers to the FLP or LLC.  To date, none of the concerns by the critics of this approach have been supported by any published court cases.

Foreign Based Assets

U.S. Trust Converts to a Foreign Trust at the Last Minute

Putting Assets into a Foreign IBC, CFC, LLC

If the assets are to be transferred to a foreign trust, then there are further options regarding how those assets are held. They can be held directly in the name of the trust.

But many foreign banks will not sell securities to a foreign trust that was created by a U.S. person because of their concern about the U.S. SEC. To avoid those problems, the foreign banks often suggest that the assets be held in a foreign corporation owned by the trust. In many offshore jurisdictions, there is an entity known as an International Business Company or IBC. That entity is a corporation that is simply prohibited from engaging in a business in competition with anyone in the local economy. The IBC is explicitly permitted to manage investments, because that often provides employment opportunities to local residents.

From a tax perspective, an IBC is a very poor choice to hold investments.  In almost all cases it will be classified as a controlled foreign corporation for tax purposes with the following negative tax results:

• All capital gains are converted to ordinary income and taxed at the ordinary tax rate – not the 15% dividend tax;
• A CFC is taxed as a modified flow through entity, with all income taxed currently, but any loses are suspended in time until the CFC liquidates;
• To the extent that the CFC invests in U.S. dividend paying securities, there is a true double tax.:  once when the U.S. payor withholds income tax under the rules of IRC Section 1441, and a second time under the modified hybrid flow through taxation.

Another option is to hold assets in a foreign limited liability company which creates an added layer of asset protection. From a tax and asset protection perspective this is one of the most favorable options.  There is one level of tax and capital gains retain their character as capital gains.  Also, some of these jurisdictions, such as Nevis, provide that the charging order is the sole or exclusive remedy of the creditor.  However, one needs to be wary because some jurisdictions, such as the Isle of Man, adopted a poor U.S. LLC statute, and these jurisdictions do not even provide for charging order protection.

In some cases, some of the foreign trust’s assets may actually be owned by a foreign partnership.  Again, from an asset protection perspective, foreign partnership law will need to be reviewed to see if charging order protection is available. From a tax perspective, the ownership of assets by a foreign partnership provides pass-through tax treatment.

Sometimes the foreign trust will invest the assets in a passive foreign investment company (PFIC), a foreign annuity or a foreign life insurance policy. Each of these alternatives has different tax consequences for the U.S. grantor.  In particular, foreign mutual funds should be avoided  unless they meet the IRC requirements for a PFIC QEF status[ii] or are classified as a partnership for U.S. tax purposes.

Planners who disagree[iii] with many of the conclusions reached by these critics tend to focus on the blatant fraudulent conveyance fact patterns underlying these cases.  They also note the emerging trend where now eight states have sanctioned domestic asset protection trust statutes.  Finally, to some unknown degree, even the new Bankruptcy code under Section 548 provides some acknowledgement regarding the validity of this type of planning.  (Mark Merric)

Available Litigation is Unfavorable

Of the cases that have been published regarding foreign asset protection trusts, (which as noted above almost all of these cases contained blatant fraudulent conveyance patterns), the results have been generally unfavorable to the trust grantor. In a few of the most abusive cases, the U.S. courts concluded that the trust grantor had the power to recover the assets and put the grantor in jail for contempt until they elected to repatriate the assets.  As noted above, this has resulted in a split of opinion with some planners, Adkisson and Riser take the position that a domestic court will automatically void a foreign trust, without legal argument, based solely on the fact that it is a foreign trust.

Supporters of the FAPT[iv] generally acknowledge that with a blatant fraudulent conveyance pattern, a result oriented trial judge will attempt to bend, if not break, many legal principles in order for a plaintiff to recover. However, even with these incredibly bad fact patterns, supporters of the FAPT have observed that in most of these cases the plaintiff, was not in fact able to recover the assets, and the creditor settled for substantially less than would have been received had a domestic asset protection solution been utilized.

In the most abusive cases, based on both defective design of the asset protection trust and blatant fraudulent conveyance patterns, most supporters of FAPTs agree that a judge should have used his or her contempt powers under the circumstances and incarcerated the settlor of the APT.  These supporters generally note that the result would have been the same had the settlor used a domestic FLP, domestic APT, or a Nevada corporation under the same fraudulent conveyance pattern.Supporters of FAPTs also generally agree with the opponents of FAPTs that having to choose between your freedom or your assets is not exactly a victory.  However, supporters of FAPTs also note that planners should not in anyway be actively involved in helping their clients complete fraudulent conveyances in the first place.

Advocates of the foreign trust also point out that in most cases there is an incredible daunting effect with a creditor that is not present with domestic solutions.  The result in many cases is that the creditor will settle with the debtor for a fraction of the amount of the judgment or will often simply give up on attempts to collect on the judgment award.

Foreign Trusts Are Being Marketed as Products

Some lawyers who are critical of the FAPT  point out that foreign promoters, non-lawyers and some U.S. lawyers are selling foreign trusts as if they were boxes of cereal. The promoter would prepare a boiler-plate set of forms designed to comply with local law regarding the formation of the trust, but the trust grantor is responsible for making any modifications to the trust agreement. However, this is more of a criticism of the planner rather than of the foreign trust because the same argument can be made regarding a FLP, LLC, a domestic corporation or a domestic trust.

Trust Grantor Has Limited Recourse against Fraud or Incompetence

A somewhat practical criticism of the foreign asset protection trust is that the trust is being formed to make it more difficult for U.S. creditors to recover the assets in the trust. To do that effectively, the U.S. grantor must relinquish control over the trustee and must transfer ownership of various assets to the foreign trustee. In the event that the foreign trustee proves to be either incompetent or unscrupulous, the U.S. grantor will be in the same difficult position as a potential creditor. The U.S. grantor will have to seek recovery of the assets in a hostile legal environment.

Presumption of Intent to Defraud Creditors (Fraudulent Transfer)?

It may be expected and some of the court cases against the grantors of foreign trusts have shown that U.S. judges don’t like to have their authority circumvented by putting assets beyond their jurisdiction and control. Unfortunately, almost all of these cases involve fact patterns that would constitute a blatant fraudulent conveyance regardless of whether the assets were transferred to a family limited partnership, a domestic asset protection trust or a foreign trust.  Under an obvious fraudulent conveyance fact pattern, it is easy to understand why a judge becomes frustrated when a debtor has moved assets outside the reach of the U.S. courts. Some planners expressing concerns with FAPTs have claimed that there is an attitude on the part of some U.S. judges that a foreign trust is a prima fascia attempt to prevent the court from providing redress to plaintiffs and is an indirect method of defrauding creditors.  (Adkisson and Riser).  Other planners believe the holdings of these cases are much more the result oriented nature of many, if not most, judges and these holdings turned on the blatant fraudulent conveyance fact pattern.  [v]

Settlors Put All Assets in Trust and Then Want Total Control

One attorney has referred to the foreign trust as the “Final Step”. His approach is to advocate the use of a variety of asset protection methods and to only put a nest egg of assets into a foreign trust as a protection against a worst case situation. The problem with that argument is that foreign trusts are usually rather expensive and the trust grantor is therefore tempted to put most or all of his assets into the most powerful form of asset protection rather than to utilize a diversified approach.

But this then leads to a normal desire to retain nearly total control over the assets and/or the trustee. Such control can lead to having the trust treated as a mere agent or nominee of the trust grantor and excessive control will make it much easier to convince a domestic court that the trust is not a valid trust.

Lack of Solvency When Funding a Foreign Trust

One of the key methods of challenging a transfer of assets to a trust or other person without full and fair payment for the property transferred is to argue that the purpose of the transfer was to hinder, delay or defraud current or future creditors. A full explanation of this concept can consume a large part of a large book, but a key element in the defense against a charge of a fraudulent transfer is that the transferor was financially solvent after the transfer.  For this purpose, solvency is not the same as for general accounting purposes and an explanation is beyond the scope of this discussion. But, the bottom line is that if the transferor is solvent and able to meet his obligations after making a transfer to a foreign trust, it will be more difficult for any creditor to challenge the legality of the transfer and to convince a domestic court to repatriate the assets in the trust.

Adverse Litigation

The following are very brief descriptions of some of the more prominent cases relating to foreign asset protection trusts.

The Andersons vs. the FTC (1988)

The Andersons put 98% of their interest in a US limited liability company into a foreign trust in the Cook Islands. The LLC received millions from a fraudulent investment scheme that was being promoted on t.v. infomercials. The Federal Trade Commission sought to recover the funds before they had proven their case regarding the legitimacy of the income in the LLC. The Andersons were co-trustees and trust protectors of their Cook Islands trust. The U.S. District Court in Nevada ruled that the Andersons should return the funds from their Cook Islands trust but the Andersons replied that they were unable to do so because of the duress clause in the trust agreement. Foreign trusts were typically drafted to provide that if the US settlor/grantor was under court duress, the foreign trustee should ignore any requests of the settlor to make distributions or to change the trustee or the trust protector.

The court did not believe the Andersons and put them in jail for contempt of court until they would agree to repatriate the funds in their foreign trust. (U.S. District Court, District of Nevada, 1988)  Nonetheless, the trustee of the trust refused to return the assets. Thus, the trust did protect the assets of the Andersons but the Andersons spent some time in jail despite their inability to recover the assets from the foreign trust.

This case has engendered extensive commentary and diverse conclusions as to its import. But it did put practitioners on notice that if the settlor/grantor of a foreign trust appears to have control over the assets or over the trustee, the US courts are likely to test the resolve of the trust grantors with some time in jail.

Groupo Mexicano (U.S. Supreme Court)

Shortly after the Anderson case, the U.S. Supreme Court issued a decision that some asset protection advisors believe is at odds with the 9^th Circuit Appeals Court decision in the Anderson case. Some asset protection advisors concluded from the Anderson case that foreign A.P. trusts were likely to be disregarded by the courts. Two days later, a 5 to 4 majority of the Supreme Court ruled that federal courts could not be used to obtain injunctive relief to prevent the dissipation of assets before a court has granted a judgment to the plaintiff. Basically, the S. Ct. held that adequate remedies were available via state law in the form of fraudulent transfer laws.

Stephen Jay Lawrence vs. Bear, Sterns

Stephan Jay Lawrence was a bankruptcy case in which Lawrence was seeking to be absolved of about $20.4 million resulting from the conclusion of an arbitration dispute with the firm of Bear, Sterns and Co.  Nearly 90% of Lawrence’s remaining assets were in a trust in the Republic of Mauritius at a time when creditors were in hot pursuit.  Lawrence did have the power to inform the foreign trustee that he was being compelled to return the funds and this triggered the duress clause in the trust. Lawrence blatantly lied to the Bankruptcy judge, and among other ridiculous statements, informed the judge he did not know where the trust assets were.  The court incarcerated Lawrence to encourage him to find a way to recover the assets in the trust, but the trustee would not comply.

Robert E. Brennan vs the SEC

The New York Law Journal reported on Oct. 30, 2000 that "Disgraced penny stock mogul Robert E. Brennan will not be forced to repatriate $5 million from an offshore asset protection trust following a ruling Oct. 26 by the 2^nd U.S. Circuit Court of Appeals."

However, this case is not about whether Brennan should be ordered to return the assets. It's more of a bankruptcy procedural issue involving the "automatic stay" provision of the Bankruptcy Code. According to Black's Law Dictionary, "Immediately upon the filing of a voluntary petition under the Bankruptcy Code, a stay arises which generally bars all debt collection efforts against the debtor." Thus, the Circuit Court basically held that the SEC could not get preference over other creditors based on the SEC's claim that there is an exception to the automatic stay for a "government unit to exercise its police and regulatory power." 

Elizabeth Weese vs. Bank of America

The Weeses defaulted on a $17 million promissory note to the Bank of America.  On the day the arbitration proceedings began, Elizabeth Weese created a Cook Islands trust (the Book Worm Too Trust), and moved most of her assets, which included the family's $3 million home, offshore.  Later, Elizabeth Weese transferred numerous other assets into the trust, including limited liability partnership interests, stocks, bonds, and household furnishings, according to Memorandum Opinion and Order issued by the Circuit Court for Baltimore County.

The circuit judge, Christian M. Kahl, granted an injunction that froze the offshore trust assets  Subsequent to the granting of the injunction by the Circuit Court on June 12, 2001, Bank of America filed a lawsuit in the Cooks Islands that mirrored the lawsuit filed in the Circuit Court.  In addition, Bank of America sought and obtained an ex parte order from the Cook Islands that granted a Mareva Injunction.  The Mareva Injunction required the trustee to transfer all trust assets held at Bank Sarasin, a Swiss bank, to a bank within the jurisdiction of the Cook Islands Court.  The Mareva Injunction also prohibits the trustee, the Weeses and others from taking action that may have the affect of the transfer and disposing or in any way dealing with the trust assets, changing the governing law from the Cook Islands, removing the administration or management of the trust from the Cook Islands to any other jurisdiction, from appointing or permitting to be appointed any successor trustee of the trust, from the removal or resignation of the trustee and from removing or substituting any beneficiary of the trust. (Source: J. Richard Duke, JD, LL.M., -- www.assetlaw.com )

Reichers v. Reichers

Reichers is one of the only FAPT cases that does not have blatant fraudulent conveyance facts.  The result is a ruling in favor of FAPTs and APT planning in general.  The trial court specifically mentioned that creating a FAPT for protection of claims from malpractice was specifically a valid reason for planning.  Further, the appellate court upheld the trial court decision that the laws of the Cook Islands governed the trust under conflict of law principles and the court did not have jurisdiction over the Cook Islands trust.  

Where the trial court and the appellate court took issue with Reichers is that he transferred marital property to the trust, and the trust was being used to shield these assets from his former spouse.

APTs and the 2005 Bankruptcy Reform Act

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (S-256) is the first major bankruptcy reform law since enactment of the law in 1978. (CCH)  A number of the provisions of the act directly or indirectly affect grantors of asset protection trusts, whether domestic or foreign. Other provisions of the act affect alternative methods of asset protection, which are described below. Also, bankruptcy attorneys and consumer advocate groups argue that there is little in the new law that provides added protection to consumers or those who file for bankruptcy. They argue that this bankruptcy law has been bought and paid for by the large banks and credit card companies.

Virtual Elimination of a Fresh Start for Affluent Debtors

The new law establishes a complex means test to determine if a debtor can qualify for the Chapter 7 discharge of debts or must use the Chapter 13 repayment plan. In general, anyone with an income in excess of the average income in their state will be unable to use Chapter 7 – which wipes out the outstanding debts and allows the debtor to start over with a clean slate. Anyone with sufficient assets to establish an asset protection trust is not likely to be eligible for the Chapter 7 relief.

Discharge for Assets in a Self Settled Spendthrift Trust (APT) Depends on Whether Intent is Proven under Fraudulent Conveyance Laws

A bankruptcy trustee may void any transfer to a self-settled trust made within 10 years where the debtor is a beneficiary and the debtor made the transfer with an actual intent to hinder, delay or defraud a current or future creditor.  There is no grandfather exemption for trusts formed before the effective date of the new law, which is on October 17, 2005 for most provisions of the act.

Actual intent must be proved by traditional methods, which includes cases establishing “badges of fraud” – such as making gifts to others when insolvent. 

Since actual fraud (not constructive fraud) must be proven, the solvency analysis at the time of forming either a domestic or foreign asset protection trust is crucial.  For example, some planners in the past would transfer 90% plus of a client’s assets into an APT.  In many, if not most cases, this type of planning may well be a determinative factor leading a court to conclude the intent was to defraud a creditor.  In this regard, while an APT may still serve as one of the primary components of an asset protection plan, assets should always be available to satisfy present claims, and other asset protection tools should be utilized to complement the overall plan.

Other factors showing purposes other than just asset protection should be used when creating APTs.  For example, creating the foreign trust to hold foreign securities is an investment reason behind the structure.  ,  A foreign trust may be used as an element in a foreign business venture or an integral part of a family estate plan.

First, many promoters of the domestic APTs are claiming that the Bankruptcy Act now sanctifies APT planning – even for settlors that do not reside in APT states.  Whether, there will be conflict of law issues under the Full Faith and Credit Clause of the U.S. Constitution and Supremacy issues for domestic APTs still remains to be seen for out of state settlors.  However, it may be noted for in state settlors, the Bankruptcy Act definitely accepted the APT as a legitimate planning tool, subject to proving actual intent of a fraudulent conveyance.  Second, as for foreign trusts, absent a blatant fraudulent conveyance case, the bankruptcy trustee  most likely will not be able to force the foreign trustee to repatriate the assets in the trust, but the judge can deny a discharge in bankruptcy unless the assets are returned.

New Law Encourages APT Grantors to Avoid Bankruptcy

The new bankruptcy rules apply where a debtor has requested relief from debts through the federal bankruptcy system or where bankruptcy has been forced on the debtor by the action of creditors.  Previously, the threat of bankruptcy was a major bargaining chip available to debtors – even to those with assets in an APT.  Now, the objective will be for the grantor of a foreign trust to avoid bankruptcy in order to preserve the assets in a foreign asset protection trust.

Summary of the New Bankruptcy Law by CCH

http://www.cch.com/bankruptcy/Bankruptcy_04-21.pdf

An Extensive Introduction to Bankruptcy and the New Reform Act

http://www.ws5.com/bankruptcy/

Asset Protection and the New Bankruptcy Law (J.B. Alpers)

http://www.alperlaw.com/new_bankruptcy_law2.html

http://www.risad.com/Dev_May2005.htm

Redline of Title 11, 28 and 18 of the U.S. Code as Enacted by

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

(199 Pages in PDF format)

http://www.sasmf.com/content/Publications/Publications1016_0.pdf

Tax Rules for Foreign Trusts

One of the greatest frustrations encountered by those who want to establish a foreign trust is learning to deal with the highly complex and ambiguous U.S. tax rules that apply to the U.S. grantors and beneficiaries of a foreign trust. In addition, where the foreign trust is an owner of (or partner in) a foreign corporation or IBC, a foreign LLC or foreign partnership, those additional complex tax rules must be faced. And even further complications face the grantor of a foreign trust that is actively investing in foreign mutual funds, foreign annuities, foreign life insurance or foreign currencies.

Foreign Trusts before 1976 (IRC 679)

A lot of people seem to believe that it is legal for a U.S. person to put assets into a foreign trust and to not pay taxes on the income earned by those assets until the income is distributed to someone in the U.S.  That was true before 1976. The 1976 tax law introduced tax code section 679 which basically states that if a U.S. person forms a foreign trust and if that trust has any living U.S. beneficiary, the trust will be treated as a grantor trust. That means that the trust settlor/founder is deemed to be the owner of the assets in the trust for income tax purposes.  Thus, the tax treatment is substantially the same as for a revocable living trust except that the grantor of a foreign trust is subject to a variety of much more complicated tax rules.

The 1996 and 1997 Tax laws

Despite the change in the law in 1976 with respect to foreign trusts, the establishment and operation of foreign trusts had evolved into somewhat of a “wink and nod” activity. Since the foreign trustee was not subject to the jurisdiction of the U.S. courts, the Congress could not pass any laws forcing them to disclose the amount of the income earned by the trust. The IRS was therefore unable to enforce the rules enacted in 1976.  The 1996 and 1997 tax law included new rules with severe penalties for U.S. grantors and beneficiaries of foreign trusts who did not file the required reports – regardless of whether the foreign trustee was required to disclose the income of the foreign trust. The penalties apply for a mere failure to file the forms, regardless of whether there is any income to report or whether the trust incurred a loss.

Tax Treatment of a Foreign Non-Grantor Trust

A grantor trust for U.S. tax purposes is a trust in which the U.S. settlor is required to pay taxes on the income earned by the trust. A foreign trust, as explained above, is now treated as a grantor trust simply because it is a foreign trust. A foreign non-grantor trust is therefore a foreign trust that is not a grantor trust. A foreign trust is a non-grantor trust if it does not have (1) a living U.S. grantor/settlor, or (2) any living U.S. beneficiaries.  A foreign non-grantor trust can be created by the will of a U.S. person upon their death. It therefore benefits future generations of heirs but does not directly benefit the grantor.

Tax Treatment of Foreign Investments

Because the U.S. grantor of the foreign trust is deemed – for income tax purposes only – to be the owner of the assets in the trust, the trust becomes transparent for tax purposes and all of the income and expenses of the trust are reported on the tax return of the grantor as if the trust did not exist. Any tax forms that must be filed because of ownership of various foreign entities or investments must therefore be filed by the trust grantor.

Tax Treatment of U.S. Beneficiary of a Foreign Trust

In order to secure favorable tax treatment on distributions received from a foreign trust, a U.S. beneficiary is required to provide information to the IRS regarding the details of the distributions. If the beneficiary can’t do that, the distribution is subject to a punitive and complex method of taxation.

Tax Treatment of Foreign Entities Owned by the Foreign Trust

Because the U.S. grantor of a foreign trust is deemed to be the owner (for income tax purposes) of the assets owned by the foreign trust, the grantor may be required to file the various information returns that are required by certain shareholders of a foreign corporation (or IBC or LLC), by certain partners in a foreign partnership or joint venture (including some foreign limited liability companies) and where the owner of an eligible foreign entity elects to treat the entity as a disregarded entity for tax purposes.

Tax Forms That May be Required

Form 709 – US Gift Tax Return (Transfers to an irrevocable non-grantor foreign trust)

Form 720 for premiums paid to foreign insurance companies

Form 926 for transfers of property to a controlled foreign corporation

Form 1041 to report the income and expenses of a grantor trust

Form 1040NR to report U.S. source income of a non resident alien and foreign trust

Form 3520 for transactions with or distributions from a foreign trust

Form 3520-A to report the income, expenses, assets and debts of the foreign trust

Form 5471 for a controlled foreign corporation owned by a foreign trust

Form 8621 to report income from or dispositions of a foreign mutual fund

Form 8832 to elect to have a foreign entity disregarded for U.S. tax purposes

Form 8833 to report a treaty based return position

Form 8858 to report the income, expenses, assets and debts of a disregarded entity

Form 8865 for a controlled foreign partnership owned in part by a foreign trust

Form TDF 90-22.1 and Foreign Financial Accounts Disclosure

For more information about these tax forms see

http://www.offshorepress.com/AICPA/

For a free web book introduction to the U.S. tax treatment of foreign investments and entities, see http://www.offshorepress.com/offshoretax/

Money Laundering and the FAPT

When the Property Becomes the Criminal

The most insidious aspect of the forfeiture laws is that ownership of the property doesn't matter, because it's the property that is being accused of a crime. Therefore, the location of the asset is more critical than the legal ownership. The concept was revived to help finance the agencies that are involved in trying to put drug dealers in jail. Before long, the law was modified to include any property that is associated with any crime. Eventually, the slightest connection between any asset and any crime was sufficient to confiscate the asset. The government only needs to allege that there is a connection with the property and with a crime. 

Impact on Financial and Legal Advisors

Lawyers or financial advisors can be accused of money laundering for merely providing services to someone who is accused of money laundering.

Money laundering is an illusive concept that includes almost any kind of financial transaction in which funds are merely alleged to be illicit. You must be aware of these laws if you or your clients are involved with any foreign entity or trust, using a foreign bank account, or doing business with a foreign country. "Illicit" funds include unreported accounts and transactions involving concealment. You may be called upon to justify your actions if any representatives of a financial organization question whether a financial transaction is "normal."

Drug War and Money Laundering

The following are some of the laws that have led to the current ability of law enforcement agencies to use forfeiture laws as a form of funding for their agency.

• The Racketeering and Corrupt Organization Act – RICO (1970)
• The Bank Secrecy Act (1970)
• The Comprehensive Forfeiture Act (1984)
• The Money Laundering Control Act of 1986
• The Money Laundering and Financial Crimes Strategy Act of 1998
• The USA Patriot Act (2001)

Offshore Trust Jurisdictions

A common question by those considering the use of a foreign trust is “Where is the best jurisdiction?”  The answer is usually dependent on the lawyer (or other entity promoter) who is helping to establish the trust.  Each foreign trust advisor has to develop a network of trust professionals such as the trustee, banks, lawyers, accountants and others in each jurisdiction that is utilized. Except for a few very large international law firms, most asset protection lawyers will tend to favor two or three jurisdictions.

Aggressive Foreign Asset Protection Trust Legislation

The Cook Islands is reputed to have the strongest asset protection trust legislation, but some of the Caribbean Islands have developed legislation that is comparable.  A key element is the stature of limitations to bring a suit in the local courts charging that the trust assets should be repatriated because of a fraudulent transfer. Jurisdictions with a one year statute of limitations include the Bahamas, Cook Islands, Nevis, Mauritius, St. Vincent, the Grenadines and the Turks and Caicos.  Other asset havens used by various planners include Anguilla, Belize, the Cayman Islands, Gibralter, Luxembourg, Panama,  St. Lucia, and Switzerland.  Each of these jurisdictions offer different advantages and disadvantages other than their respective trust legislation.

Government, Laws, Taxation and Political Stability

A stable, democrat political environment is a critical factor in selecting a trust venue. Generally, lawyers who form foreign trusts favor a country with a common law history that evolved from England. However, a few prefer countries like Panama and Luxembourg where the legal entities are defined by statute.  Most asset protection havens are also tax havens in that they only impose a tax on income from domestic sources and many of them do not permit the entities they form to compete in the local economy.

Location, Infrastructure, Economy, Climate

One of the advantages of the Cook Islands is that it is very time consuming and costly for a judgment creditor to pay for a U.S. attorney to go there and retain local counsel to pursue a court decision regarding assets in a Cook Islands trust.  (The Cook Islands is a few hundred miles east of Australia.) On the other hand it is equally costly for the trust grantor to visit the island and to get acquainted with the people who will be managing the assets in his trust. By comparison, it’s very easy for someone from the U.S. to visit the Bahamas or Belize.

Some people may like a primitive life style but most people with substantial assets prefer the comforts of modern living. An attractive and well kept local infrastructure including streets and airports are therefore important – as well as the availability of modern style hotels.

An important selection criteria is an economy that is not heavily dependent on the business of forming trusts and foreign corporations – usually known as International Business Companies or IBCs.

For most people in the U.S., the climate is an important consideration. Many of the foreign trust havens are in the tropics and some are close to the equator – which makes them very uncomfortable during the summer.

Treaties, MLAT, Bank Secrecy, KYC

A significant element in the selection of a trust venue is the extent of cooperation with the US regarding crimes, tax matters and money laundering laws. The U.S. has tax treaties with nearly every major country that has an income tax. The U.S. also has Mutual Legal Assistance Treaties with over two dozen countries and has Tax Information Exchange Agreements with over a dozen countries.

Different countries – including the asset and tax havens – have responded differently to pressure from the large industrial countries like the U.S. regarding the establishment of money laundering laws and Know Your Customer rules for local banks.

Banking, Trust, Legal and Accounting Services

Many of the countries that are part of the United Kingdom or have been U.K. territories have an established work force of well qualified financial and legal professionals such as lawyers, accountants, investment experts, trustees and bankers. Some of the countries are so small however, that there only a few of each in the country – which may make it difficult to find a qualified professional or to get work done on a timely basis.

Asset Protection Trust Statues that Contribute to Greater Asset Protection

• Short statute of limitations (Two years in the Cook Islands)
• No contingency fees
• Loser pays all and plaintiff pays advance fee to local court
• A trust protector can retain veto powers over the trustee
• The foreign trust can pay taxes & expenses of a beneficiary

Foreign Trust Scams and Schemes

People who are concerned about losing their assets in a lawsuit want some way to protect those assets but they also want to avoid taxes and to retain control over the assets and/or the trustee of a foreign trust. There is an abundance of foreign trust promoters outside the U.S. who are eager to get a wealthy U.S. person to put their assets into a foreign trust structure and will help the U.S. person to devise schemes that are either patently illegal under U.S. law or are highly unlikely to survive a challenge by the IRS.  The following are brief descriptions of a few of the many schemes and scams that are still being promoted through the Internet.

Schemes to Retain Control of Trust Assets

Instead of transferring the assets directly to a foreign trustee, the grantor puts the assets into an entity such as a limited partnership, limited liability company, foreign corporation or International Business Company that is then owned by the trust. However, the trust grantor becomes the manager of the entity that holds the assets – thereby retaining personal control over those assets. When there is a threat of a lawsuit, the intent is for the trust grantor to resign as the manager of the separate entity in favor of the trustee or some other person acting on behalf of the trust grantor.  By holding the assets in a foreign corporation or IBC, the trust grantor will argue that the trust has no income and will argue that he has no ownership of the assets in the corporation or IBC because the entity is owned by a foreign person – i.e. the foreign trust.  These arrangements only succeed for a time because of the difficulty the IRS has in determining when someone has assets offshore and is not reporting the income. But over a period of many years, the chances of being caught increase. (See the Secrecy Myth.[vi] )

Another variation on the effort to have control over the assets in the trust has been to hold a debit card drawn against the bank account of the trust.  The IRS has discovered this scheme and has developed an aggressive program to locate promoters of this arrangement in order to then locate the taxpayers who have been using debit cards on offshore accounts without disclosing them and without paying tax on the income of the account or trust.  (See Tax Amnesty for Offshore Accounts[vii] )

Schemes to Control the Trustee

Some promoters have been a bit more subtle and have developed arrangements in which the trust grantor is convinced he can control the actions of the foreign trustee. Generally, these arrangements involve an individual trustee affiliated with the promoter rather than an institutional trust service that is independent of the person who organizes the trust. One way that the trust grantor attempts to control the trustee is with a “Letter of Wishes” – which set forth the expectations of the trust grantor that are outside the scope of the trust agreement. Usually, these expectations are simply instructions on how to manage the investments or on how and when to distribute assets to the trust grantor as one of the discretionary beneficiaries of the trust.

Schemes to Hide the Identity of the Trust Grantor

A variety of offshore trust schemes involve the use of methods to hide or disguise the identity of the actual grantor of the foreign trust. The most common is an arrangement where the trust promoter has an associate who is not a U.S. citizen or resident and who agrees to be the accommodation grantor of a foreign trust on behalf of the actual trust grantor. Apart from the tax evasion issues, the greatest risk of this arrangement is that the foreign person serving as the trustee won’t be particularly trustworthy and will steal a lot of the trust property in the form of excessive fees and expenses.

Another common method to hide the identity of the U.S. trust grantor is to form a bearer share foreign corporation/IBC and to have a nominee act as the owner of the foreign corporation.  An argument is made that the foreign trust is a non-grantor foreign trust because it does not have a U.S. grantor.

Schemes to Avoid Classification as a Foreign Trust (Foundation)

Another scheme that is being promoted to attempt to avoid the foreign trust and foreign corporation reporting rules and the taxation of the income earned by the assets in the foreign trust is to use an entity that is not comparable with any of the entities used in the U.S. A popular device of this type is the Liechtenstein and Panamanian Foundation. This entity can be organized like a trust, like a corporation or as a hybrid with some of the elements of each. The foreign promoters argue that since it is neither “fish nor fowl”, its income is not subject to tax by the U.S. government. The problem is that the Treasury Regulations require the founder who establishes the foundation to determine the tax classification as either a foreign trust or a foreign corporation; and that the tax classification determines appropriate tax returns that must be filed with respect to the foreign foundation.