by Scott St. Amand
The average American has long viewed the use of foreign financial institutions to “shelter” assets with great skepticism. The release of the “Panama Papers” in April 2016 renewed the collective, latent distaste for such shelters, including the offshore asset protection trust (OAPT), which traditionally offered unparalleled protection from the claims of creditors. Because the laws of the individual states were, until recently, uniformly hostile toward self-settled asset protection trusts, domestic settlors often considered OAPTs to be the only viable asset protection vehicle available to them. Over the last two decades, however, 16 states have taken steps to create a statutory framework, which mirrors that of offshore jurisdictions by permitting self-settled, domestic asset protection trusts (DAPTs).1 In addition to comparable asset safeguards, DAPTs in certain jurisdictions offer both tax and nontax advantages over their foreign counterparts. As a consequence, practitioners and settlors alike must consider whether the historic benefits of OAPTs currently outweigh the negative connotations, tax treatment, and compliance burdens intrinsic to such foreign trusts.
Asset protection trusts, domestic and foreign, are generally self-settled spendthrift trusts, i.e., trusts created for the primary purpose of protecting a settlor’s own property from the claims of his or her creditors. Most DAPTs are classified as grantor trusts due to the settlor’s retention of certain powers enumerated in I.R.C. §§671 through 677.2 Additionally, an OAPT settled by a U.S. person with U.S. beneficiaries will be considered a grantor trust — whether or not the settlor retained any of the aforementioned enumerated powers.3
Even though both DAPTs and OAPTs are considered grantor trusts under the code, their respective treatment by the Internal Revenue Service is substantially different, particularly in regard to the taxation of the trust’s income and capital gains. By way of example, to the extent that distributions to DAPT beneficiaries carry out the trust’s distributable net income (DNI) for the year, a DAPT will receive a deduction in calculating its taxable income.4 Distributions of DNI to the beneficiaries of a DAPT will generally constitute ordinary income and will be taxed at the beneficiaries’ applicable income tax rate. Unlike ordinary income, a DAPT’s capital gains generally do not enter into the calculation of DNI.5 In contrast, OAPTs must include ordinary income and capital gain in DNI.6
If an OAPT does not distribute every penny of its DNI in the current year, any after-tax portion of the undistributed DNI is considered undistributed net income under a set of provisions colloquially known as the “throwback rules.”7 The throwback rules treat the later principal distribution as being comprised of the previously undistributed DNI. This “accumulation distribution” is carried back to the beneficiary’s earlier tax years in which the income was originally generated by the trust.8 In effect, the throwback rules result in an income tax being levied at the OAPT beneficiary’s highest marginal tax rate for the year in which the OAPT earned the income (or gain). As a result, any capital gains that the OAPT accumulated for distribution in a later year lose their capital character and are treated as ordinary income.9 Further, the throwback rules add an interest charge to the distribution in order to offset any of the tax benefits that the taxpayer may have obtained by accumulating and not immediately distributing the OAPT’s income.10
In addition to these substantive tax consequences, the reporting and compliance requirements are significantly higher for OAPTs. Prior to the enactment of the Small Business Job Protection Act of 1996 (SBA),11 reporting was relatively nonexistent, as the penalties for failing to file the required returns amounted to approximately $1,000 per missed return, without regard to the size of the trust.12 The SBA significantly increased the penalties for failure to report OAPT transactions.13 Not only are the penalties exacting, but also the scope of required disclosure is extraordinary. The IRS requires disclosure even if providing such information would subject the OAPT’s owner to penalties in the country where the trust is sitused due to that country’s secrecy laws.14
In 2010, Congress enacted the Foreign Account Tax Compliance Act (FATCA)15 to more comprehensively target noncompliance by U.S. taxpayers using foreign accounts to shelter assets.16 FATCA opened the door for an OAPT to be treated as a “foreign financial institution.” If an OAPT were so treated, remittances to it of “fixed or determinable, annual, or periodic” income would be subject to federal withholding taxes.17 FACTA materially increased the SBA’s compliance and reporting requirements due to the expanded scope of persons who might be deemed to have a reportable interest.18 Importantly, the majority of the reporting requirements of FATCA and the SBA may be avoided if the OAPT is domesticated.
Although OAPTs have become subject to increasingly negative tax treatment and substantial, costly compliance and reporting requirements, domestic settlors still often prefer OAPTs over DAPTs largely due to historic predilections. One of the longstanding benefits, which drove past trust business offshore, was that OAPTs were perceived to be invulnerable to judgments and orders of U.S. courts. This perception arose because U.S. courts have great difficulty exercising personal jurisdiction over a foreign trustee with only limited contacts to the forum state; further, foreign courts have generally been unwilling to enforce the judgments or orders of a U.S. court.19 As a result, creditors seeking to enforce a domestic judgment in traditional offshore jurisdictions were often forced to re-litigate their claims in accordance with foreign laws at a significant out-of-pocket cost.20 Today, however, domestic courts and creditors have discovered increasingly effective methods by which they may pursue claims against offshore trusts and the settlors thereof.21
Although prophylactic action to prevent a debtor-settlor from creating an OAPT is the most effective way to assure that a creditor’s rights are not frustrated, once a creditor has settled an OAPT, all is not lost. Indeed, with the cooperation of Swiss authorities, U.S. courts have frozen Swiss trust accounts22 and have even compelled Swiss banks to disclose information about bank-held trust accounts in spite of Swiss secrecy laws.23 In order to further encourage compliance in such cases, U.S. courts have levied substantial daily fines against domestic settlors and the domestic branches of foreign banks.24
U.S. creditors have been especially successful in pursuing OAPT debtor-settlors under the U.S. bankruptcy regime. For example, in the case of Brown v. Higashi, Bankr. D. Alaska No. 95-3072, 1996 WL 33657614 (1996), the debtor had set up an OAPT in Belize to shield assets from his creditors; the court, taking judicial notice of the trust’s assets, included them in the debtor’s bankruptcy estate and denied his Ch. 11 discharge. Similarly, in the case of In re Portnoy, 201 B.R. 685 (Bankr. S.D. N.Y. 1996), the debtor-settlor transferred virtually all of his assets into an OAPT with the knowledge that his personal guarantee on a domestic loan was to be called imminently. The court found that the debtor had “maliciously” employed the OAPT to shelter assets, and, as in Brown, the court denied his Ch. 7 discharge.
Outside of the bankruptcy context, U.S. courts have taken creative, indirect measures to enforce their orders and judgments, despite traditional jurisdictional barriers. In situations in which a domestic debtor-settlor has employed a large international bank as the trustee of an OAPT, there is less and less of a need to resort to bringing a foreign action.25 Indeed, there is a “growing body of law in the United States,” which provides that if a branch or affiliate of a foreign financial institution is operating within the U.S., such entity must disclose information in its possession to even a private litigant pursuant to a domestic court’s order — even if such disclosure violates the confidentiality or secrecy laws of the foreign parent’s domicile.26 It should be noted as well that U.S. courts have required such disclosure from the domestic branch or affiliate, even if the U.S. entity is not a party to the litigation.27
The use of a civil contempt order is another arrow in the quiver of domestic courts. In the case of Federal Trade Commission v. Affordable Media, LLC, No. 98-00669 (D. Nev. 1998) (order holding debtors in civil contempt), order aff’d, 179 F.3d 1228 (9th Cir. 1999), a husband and wife placed ill-gotten assets in a Cook Island trust. The trust instrument contained a “duress clause,” whereby the settlors were automatically divested of power over the trust’s assets in the event of a lawsuit. Such duress clauses were historically very effective asset protection mechanisms. However, the district court in Affordable Media held the husband and wife in civil contempt for failure to turn over the trust’s assets, despite the fact that the duress clause rendered the assets beyond their control.
Although impossibility is a legal defense to civil contempt, the bar is high, especially in cases in which the debtor-settlor has sheltered substantially all of his or her assets offshore. Indeed, the Ninth Circuit in affirming the district court’s civil contempt order in Affordable Media expressed tremendous “skepticism” that a “rational person would send millions of dollars overseas and retain absolutely no control over the assets.”28 Affordable Media serves as a paradigmatic illustration of the distaste that domestic courts have for OAPTs.29 Following Affordable Media, the Eighth and 11th circuits have likewise held that impossibility due to a debtor-settlor’s artifice is not a defense to civil contempt.30
One final remedy for domestic creditors is the most obvious, yet also the most historically unlikely. As has been discussed above, one of the long-heralded justifications for using an offshore asset protection trust was the perceived unwillingness of foreign courts to enforce domestic judgments. At least one scholar notes, however, that because the “general rule” of international law is comity, it may be “a mistake to assume that a foreign trust will not be bound by a domestic judgment in favor of creditors.”31 Nevertheless, it is at best a costly endeavor to attempt to directly enforce a U.S. judgment abroad.32 Consequently, proceeding against domestic settlors and beneficiaries of the OAPT or the domestic subsidiaries and affiliates of foreign financial institutions is the most prudent method available at present for a creditor to enforce a domestic court’s judgments and orders.
Beyond the negative consequences of OAPTs discussed above, including heightened tax and reporting requirements and the tenacious pursuit of the trusts by domestic courts, there are two additional, independent benefits offered by many U.S. jurisdictions that are unavailable in traditional offshore jurisdictions. One such advantage of DAPTs over offshore trusts formed in traditional English common law jurisdictions is the “indisposition” of U.S. courts to void trusts in which a settlor has reserved a significant amount of control over the trust’s assets.33 Such trusts are often considered to be “sham in form” by traditional common law jurisdictions and are consequently void ab initio.34 As most settlors do wish to retain substantial levels of control over the assets of their trusts, domestic jurisdictions are especially appealing.35
A second independent advantage to DAPTs is the nearly unlimited perpetuities period of certain domestic jurisdictions. Indeed, in an effort to attract both domestic and foreign trusts to settle or migrate to the jurisdiction, many of the same jurisdictions that passed DAPT legislation have also exempted certain trust interests from the rule against perpetuities or have wholly abolished the rule for interests held in trust.36 Given the advantages that have been discussed above regarding DAPTs, the additional fact that they may be established for practically perpetual duration offers an opportunity that most offshore jurisdictions simply cannot afford to potential settlors.37
If, after a thoughtful consideration of the foregoing, the settlor or beneficiaries of an OAPT desire to repatriate their offshore trust, there are three specific methods of domestication. Which method should be used depends upon the trust instrument, the jurisdiction in which the trust is to be sitused, and the desires of the trustee and beneficiaries.
The first method of repatriation involves the resignation of the foreign trustee and the appointment of a new trustee in the desired U.S. jurisdiction to administer the trust and its assets. The second method, available by statute in certain states and by common law in others, is to decant the trust by having the foreign trustee appoint or transfer the trust’s assets to a new, independently established subsidiary trust in the desired U.S. jurisdiction.38 These two methods do not require the assent of all of the beneficiaries, and are, therefore, the easiest to accomplish. If the trust has limited beneficiaries, or a trustee opposed to domestication, the third option is to have all of the beneficiaries agree to the termination of the original offshore trust, to the distribution of the trust’s principal to the beneficiaries, and to the creation of a new domestic trust in the target U.S. jurisdiction. This method has the obvious drawbacks of requiring the voluntary termination and simultaneous recontribution of assets to a second trust and may even have adverse tax consequences depending on how the IRS views the transaction.
The tax implications of the first two methods are similar in most cases. Generally, the repatriation will be treated as a continuation of the original foreign trust and not as a termination; it should not, therefore, “result in imposition of any transfer tax of any kind, [or] constitute a sale, exchange, or distribution to a beneficiary or other event of recognition.”39 The tax consequences of the third method repatriation depend upon whether the IRS views the repatriation as a one- or two-step transaction. As a one-step transaction, the tax consequences are nearly identical to the first two methods, as the modification is viewed in effect as a continuation of the prior trust. If, in the unlikely event that the IRS treats the modification as a two-step transaction, i.e., as a termination of the original foreign trust and a subsequent creation of a new domestic trust, such treatment would create significant income and transfer tax consequences.40
Although domestic trusts are by no means perfect analogues to what offshore trusts were once thought to be, they offer significant benefits that mirror and often exceed those of their offshore counterparts. Beyond the fact that the courts of law and public opinion look negatively upon the use of OAPTs, DAPTs are significantly easier to administer, more cost effective, and more tax-advantageous than their offshore counterparts; further, OAPTs are no longer as invulnerable as they were once thought to be. Finally, if a client seeks to retain significant powers in the trust or to establish a long-term dynasty trust, various domestic jurisdictions will respect the trust form and offer nearly unlimited perpetuities periods, allowing for the nigh-permanent preservation of wealth. For settlors and beneficiaries of current OAPTs, domestication is easily perfected, often with favorable tax and compliance consequences. Thus, for potential settlors or current beneficiaries looking for a long-term, tax-conscious solution with relatively stable tax, reporting, and secrecy laws, DAPTs present viable and appealing asset protection opportunities.
1 Alaska (1997); Delaware (1997); Rhode Island (1999); Nevada (1999); Utah (2003); Oklahoma (2004); South Dakota (2005); Missouri (2005); Wyoming (2007); Tennessee (2007); New Hampshire (2009); Hawaii (2010); Virginia (2012); Ohio (2013); Mississippi (2014); and West Virginia (2016).
2 Unless otherwise specifically stated, all references herein to the code are to the Internal Revenue Code of 1986, as amended.
3 Michael D. Pfeifer, Foreign Trusts: Everything You Wanted to Know about the Taxation of Foreign Trusts But Were Afraid to Ask at n.18 (citing I.R.C. §679) (Oct. 2008), available at http://www.capdale.com/foreign-trusts-everything-you-wanted-to-know-about-the-taxation-of-foreign-trusts-but-were-afraid-to-ask (If a trust has a grantor that is not a U.S. person, more limited rules apply to determine whether the trust will be classified as a grantor trust.). See generally I.R.C. §672(f).
4 Jeffrey G. Sherman, All You Really Need to Know About Subchapter J You Learned from This Article, 63 Mo. L. Rev. 1, 13 (1998); see also §§651 and 661 for distribution deductions.
5 I.R.C. §643(a)(3).
6 I.R.C. §643(a)(6).
7 I.R.C. §665(a); Treas. Reg. §1.665(a)-1A(b).
8 See Scott Andrew Bowman, Five Tax Traps for Resident Noncitizens (and Their Attorneys!), 84 Fla. B. J. 33, 36 (Dec. 2010); see also §661(a)(2).
9 Pfeifer, Foreign Trusts at n.39 (citing I.R.C. §668).
10 I.R.C. §668(a)(1).
11 110 Stat. 1755, §1907(a)(1)(E) (1996) (codified as amended at I.R.C. §7701(30) (2011)).
12 See I.R.C. §§6677 and 7203 (1995).
13 See I.R.C. §6677. By way of example, the penalty for failing to file a “notice of transfer in trust” or a “receipt of trust distribution” is the greater of $10,000 or 35 [percent] of the gross value of the property received or transferred to the OAPT.
14 See I.R.C. §6677(d) (noting that the “fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer (or any other person) for disclosing the required information is not reasonable cause” to fail to report such information).
15 Codified in I.R.C. §§1471-74, §6038D (2015).
16 See Foreign Account Tax Compliance Act, U.S. Department of Treasury Resource Center, https://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA.aspx.
17 Christopher M. Reimer, International Trust Domestication: Migrating an Offshore Trust to a U.S. Jurisdiction, 25 Quinnipiac Prob. L. J. 170, 174 (2012) (citing I.R.C. §1471(d)(5)).
18 Id. (citing I.R.C. §6038D).
19 Richard C. Ausness, The Offshore Asset Protection Trust: A Prudent Financial Planning Device or the Last Refuge of a Scoundrel?, 45 Duq. L. Rev. 147, 154 (2007).
20 Susanna C. Brennan, Changes in Climate: The Movement of Asset Protection Trusts from International to Domestic Shores and Its Effect on Creditors’ Rights, 79 Or. L. Rev. 755, 766 (2000).
21 Frederick J. Tansill, Asset Protection Trusts (Apts): Non-Tax Issues, SL032 ALI-ABA 387, 433 (2005).
22 S.E.C. v. Giuseppe B. Tone, et al., 638 F. Supp. 596 (S.D.N.Y. 1986), aff’d, 638 F. Supp. 629 (2d Cir. 1987); S.E.C. v. Certain Unknown Purchasers of Common Stock of Santa Fe Resources, Fed. Sec. L. Rep. (CCH) 99, 424 (1983); S.E.C. v. French, et al., 817 F.2d 1018 (2d Cir. 1987).
23 S.E.C. v. Levine, 1986 U.S. Dist. LEXIS 24576; Hercules Incorporated v. Leu Trust and Banking Limited, 611 A.2d 476 (Del. 1992); Litton Industries, Inc. v. Lehman Bros. Kuhn Loeb Inc., et al., 767 F. Supp. 1220 (S.D.N.Y. 1991).
24 See, e.g., U.S. v. Bank of Nova Scotia, 740 F.2d 817 (11th Cir. 1984) (ordering the Miami branch of the Bank of Nova Scotia to suffer daily fines of $25,000 pending receipt of information from the Bahamian branch of the same bank).
25 Tansill, Asset Protection Trusts (Apts): Non-Tax Issue, SL032 ALI-ABA at 435 (2005).
26 Id. (citing Societe Nationale Industrielle Aerospatiale v. U.S. District Court, 482 U.S. 522 (1987); United States v. First National City Bank, 379 U.S. 378 (1965); United States v. Vetco, 691 F.2d 1281 (9th Cir. 1981); Richmark v. Timber Falling Consultants, 959 F.2d 1476 (9th Cir. 1992)).
28 Affordable Media, 179 F.3d at 1241.
29 Id. at 1236-37 (noting broadly that offshore trusts permit settlors to “spirit” their assets away in an “intentionally designed” effort to “frustrate United States courts’ powers to grant effective relief to prevailing parties”).
30 Chicago Truck Drivers Union Pension Fund v. Brotherhood Labor Leasing, 207 F.3d 500 (8th Cir. 2000); In Re Lawrence, 238 B.R. 498 (Bankr. S.D. Fla. 1999) (ability to comply with court’s “turnover order” not impossible in spite of Mauritian trust’s asset protection language); Pesaplastic, C.A. v. Cincinnati Milacron Co., 799 F.2d 1510 (11th Cir. 1986) (holding the same as Lawrence).
31 Tansill, Asset Protection Trusts (Apts): Non-Tax Issue, SL032 ALI-ABA at 444 (2005).
32 See, e.g., Samuel P. Baumgartner, How Well Do U.S. Judgments Fare in Europe?, 40 Geo. Wash. Int’l L. Rev. 173 (2008) (noting that the perception in the U.S. has historically been that U.S. judgments do not fare very well when the time comes to recognize or enforce them abroad).
33 Reimer, International Trust Domestication: Migrating an Offshore Trust to a U.S. Jurisdiction, 25 Quinnipiac Prob. L. J. at 188 (2012).
34 Henry Steinway Ziegler, Come to America, Tr. & Est. 25 (June 2005); see also Official Assignee v. Wilson  NZCA 122,  3 NZLR 45 [Wilson] (New Zealand court held “sham” trust void ab initio); Midland Bank plc. v. Wyatt, 1 FLR 696 (1995) (English court held the transaction was a sham and, accordingly, was void and unenforceable.).
35 It is important to note that most DAPTs only permit the settlor to retain indirect control of the trust assets.
36 Robert H. Sitkoff & Max M. Schanzenbach, Jurisdictional Competition for Trust Funds: An Empirical Analysis of Perpetuities and Taxes, 115 Yale L. J. 356, 376, n.66 (2005); Helene S. Shapo, et al., Bogert’s Law Of Trusts And Trustees §214 (2016) (citing Del. Code Ann. Tit. 25, §503; AK Stat. Ann. §§34.27.051-34.27.100).
37 Tansill, Asset Protection Trusts (Apts): Non-Tax Issue, SL032 ALI-ABA at 432 (2005).
38 At least 21 states have decanting statutes. An updated list of decanting statutes can be found among the statutory compilations on the website for the American College of Trust and Estate Counsel, www.actec.org. Decanting may be available through court approval. See, e.g., Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1940).
39 See PLR 7917037 (IRS PLR), 1979 WL 54015 (1979); PLR 7917063 (IRS PLR), 1979 WL 54037 (1979).
40 The beneficiaries would be subject to tax to the extent of the foreign trust’s distributable net income, and the distributions to them would also be subject to interest under I.R.C. §668. Further, transfer tax implications may also apply under I.R.C. §§2036-2038.
Scott St. Amand is an associate with the law firm of Fisher, Tousey, Leas & Ball in Jacksonville. He practices in the areas of tax controversy and probate litigation. He received his B.A. from Wake Forest University, his J.D. from the University of Richmond, and his LL.M. in taxation from the University of Florida.
This column is submitted on behalf of the Tax Law Section, William Roy Lane, Jr., chair, and Christine Concepcion, Michael D. Miller, and Benjamin Jablow, editors.