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 2004
Index (back)
Report 4
Tuesday, January 6 (Continued)
9:00 - 9:45 a.m.
The Domestic Asset Protection Trust Comes of Age
Richard W. Nenno, Wilmington Trust Company
Reporter: John Warnick Esq.
Dick Nenno used the "Biker Bob" family to illustrate
at least seven different ways in which a domestic asset protection
trust ("DAPT") can be utilized.
The worst possible candidate for asset protection planning
is a client who has or is about to incur a large obligation
and wants to hide assets to avoid satisfying this debt.
The "best candidate" for a domestic asset protection
trust would be the client who:
1. has no current creditor problems (or at least assets
substantially in excess of what is needed to cover current
and foreseeable claims);
2. is worried about claims that might arise in the future;
3. has assets that aren't needed to meet current and foreseeable
living expenses; and
4. does want frequent access to the assets which are to
be protected.
Mr. Nenno noted that virtually all U.S. jurisdictions hold
that trusts created for third parties are generally not reachable
by the beneficiaries' creditors. Five states (Delaware, Alaska,
Nevada, Rhode Island and Utah) now recognize irrevocable self-settled
spendthrift trusts.
Mr. Nenno acknowledged a bias against DAPTs and questioned
Professor Bogert's assertion that self-settled trusts are
generally created with evil intent. After addressing the three
reasons offered for refusing to recognize DAPTs, he gave nine
reasons why domestic asset protection trusts should be recognized.
He noted that all U.S. jurisdictions have rules to set aside
fraudulent transfers and cited two recent cases illustrating
the application of these rules: U.S. v. Engh, 330 F.3d 954
(7th Cir. 2003) and Nastro v. D'Onofrio, 263 F. Supp. 2d 446
(D. Conn. 2003). Since all five of the domestic asset protection
trust states have fraudulent transfer rules, Mr. Nenno concludes
that a creditor should be able to reach assets that were the
subject of an improper transfer to a DAPT. However, domestic
asset protection trusts that do not run afoul of the fraudulent
transfer rules should be effective.
Mr. Nenno next reviewed the potential liability of an attorney
who either assists or declines to assist a client to create
a domestic asset protection trust. He noted that ethical opinions
or cases involving the propriety of an attorney's participation
in asset protection planning have come down in four states:
California, Connecticut, Oregon and South Carolina. They indicate
that an attorney might be engaging in an ethical violation
if he or she helps a client defraud known or foreseeable creditors,
but that there should be no ethical violation if the planning
involves unknown and unforeseeable creditors. He also cautioned
that the attorney cannot assume he or she will escape ethical
problems simply by choosing not to participate in asset protection
planning and noted commentators have suggested that it is
only a matter of time before a case arises questioning whether
an attorney has discharged the duty to represent a client
zealously if he refuses to promote a client's lawful asset
protection plan.
In his discussion of the tax consequences of domestic asset
protection trusts, Mr. Nenno noted that the creator of a DAPT
can choose to structure the trust as a completed gift for
federal gift tax purposes while still excluding the trust
principal from his or her gross estate for federal estate
tax purposes if the settler can only receive distributions
from the trust in the absolute discretion of an independent
trustee. Conversely, the trustor of a DAPT can intentionally
prevent a completed gift by retaining a special testamentary
power of appointment.
From an income tax standpoint, the domestic asset protection
trust will be treated as a grantor trust unless the distributions
to the trustor must be approved by an adverse party such as
a child who would receive the assets not distributed to the
trustor. Mr. Nenno also pointed out that domestic asset protection
trusts are being utilized to avoid state and local income
and intangible taxes.
Mr. Nenno acknowledged that no case has yet upheld the effectiveness
of domestic asset protection trusts. He noted that in early
2003 a rumor had circulated that an Alaska asset protection
trust had been breached. In fact, the case in question involved
a transfer from an Alaska resident to a foreign asset protection
trust that was to be administered in Alaska and was probably
fraudulent.
In his discussion of the full faith and credit clause, Mr.
Nenno refuted the argument of offshore trust proponents that
this constitutional provision and related issues are fatal
to domestic asset protection trusts. He noted that the full
faith and credit clause will only be relevant when a creditor
obtains a judgment against the trustor of a domestic asset
protection trust and tries to enforce it in the state where
the trust was created or when a creditor seeks to obtain a
judgment against a domestic asset protection trust in a jurisdiction
that doesn't recognize such trusts.
The full faith and credit clause applies to the "acts"
as well as to the "judgments" of another state.
Citing Franchise Tax Board of California v. Hyatt,
123 S. Ct. 1683 (2003), he noted that the Supreme Court has
held that the full faith and credit clause is exacting with
respect to a final judgment rendered by a court with subject
matter and personal jurisdiction but does not compel a state
to adopt a statute adopted by another state. Mr. Nenno pointed
out that the Supreme Court has also said "full faith
and credit . . . does not mean that states must adopt the
practices of other states regarding the time, manner and mechanisms
for enforcing judgments." Baker by Thomas v. General
Motors Corp., 522 U.S. 222, 235. And he cited Phillips
Petroleum Co. v. Shutts, 105 S. Ct. 2965 (1985) for the
proposition that a state court can't ignore statutes of other
states.
Dick's conclusion is that the full faith and credit clause
is more likely to protect trusts established in Delaware,
Rhode Island, Nevada and Utah that have even-handed restrictions
on the enforcement of foreign judgments than to be used as
a tool to strike down such trusts. He also pointed out that
the laws of foreign countries warrant no respect under the
full faith and credit clause.
Mr. Nenno offered the following examples of possible uses
of the domestic asset protection trusts:
1. to shield a gift or inheritance that is received outright
rather than in trust;
2. to protect children who receive significant assets at
the age of majority;
3. to protect officers and directors from heightened risks
or to allow them to use "blind" domestic asset protection
trusts to comply with security law restrictions while keeping
the ability to benefit from the trust assets;
4. to avoid state income or intangible taxes;
5. to protect the assets of clients who are mentally, physically
or financially vulnerable;
6. to protect assets from claims of future spouses and avoid
providing the type of financial disclosure that is required
to implement effective prenuptial agreements;
7. to protect personal injury awards (see In re Jordan,
914 F.2d 197 (9th Cir. 1990) for an example of where such
a trust would have been helpful);
8. to protect CRTs and other estate planning vehicles such
as GRATs, QPRTs, etc. Mr.Nenno pointed out that trustors may
be more likely to engage in sophisticated estate planning
transfers if they know that the funds might still be available
to them in the event of an emergency;
9. nonresident aliens may use domestic asset protection
trust before they immigrate to the US to remove assets from
their estates while still retaining the ability to get funds
back in the event of a future need or catastrophe; and
10. to provide protection for offshore or ineffective domestic
self-settled trusts. Mr.Nenno noted that careful consideration
must be taken to determine if such a move will causethe trustor/beneficiary
to make a completed gift.
Mr. Nenno concluded with an abbreviated comparison of the
relative benefits of some of the domestic asset protection
trust jurisdictions. For the workshop Wednesday afternoon
on domestic asset protection trusts, he has assembled a panel
of lawyers from each of the five DAPT jurisdictions. We will
report in greater detail on the comparative merits of these
jurisdictions after we listen to all five of the panelists.
2:00 - 2:45 p.m.
Bulletproofing the Family Limited Partnership Current
Issues.
John Porter
Reporter: Carol Warnick Esq.
For purposes of his discussion, the arguments used by the
Service apply to both FLPs and LLCs, but he is going to refer
to FLPs.
Various arguments have been used by the IRS to attack FLPs,
and to varying degrees of success. Some are:
1. Entity designed solely to reduce transfer taxes. (this
is really "lack of economic substance" argument.)
The IRS argument is missing a step. You must identity the
property rights that are being transferred. What is being
transferred in an interest in the partnership, either an assignee
interest or an FLP interest. As appraisers will tell you,
discounts apply for lack of control and lack of marketability.
Before you ever look at the gift, you have to see what rights
were transferred, and was full and adequate consideration
received. The partners have no rights to the underlying assets.
In both the Lappo and Peracchio cases discussed
in the outline, the Service dropped this argument. This argument
is continuing to be dropped out by the Service.
2. Section 2703 Argument.
Strangi addressed this issue. 2703 is not an estate
or gift tax inclusion statute. It is a valuation statute,
an exception to the willing buyer, willing seller test. It
is getting to buy-sell agreements and other types of restrictions
on transfer. This is what Judge Cohen said in Strangi
I that was affirmed by the 5th Circuit. 2703(b) provides a
safe harbor.
This argument is dropping out as well, but still being raised
a little. Make sure the provisions in your agreement are commercially
reasonable. Look to what kinds of restrictions are present
in nonfamily partnerships.
3. Gift on formation argument.
Courts have said that where you have a pro-rata partnership
and capital accounts are properly handled, there is no gift
on formation.
He discussed the Shepherd case where a father gifted
25% of the partnership at formation to each son. In this case
there was a gift.
The Service is trying to raise a similar argument (depletion
of value) in a properly formed pro-rata partnership, but they
are losing that argument. It may be raised at the audit level
because examining agents often throw in the kitchen sink and
expect that the real arguments will be sorted out as the case
goes along.
Stone case was a case John Porter handled. He also
just tried two other cases which have not been decided yet.
The 2036(a) argument. Elements are a transfer with a retention
of interest or retention of the right to designate the persons
who will enjoy the property.
(a)(1) involves respecting the entity. At issue here are
bad facts such as commingling assets, failure to respect entity,
contribution of personal assets (personal residence), insufficient
assets outside the partnership upon which to live (helps Service
argue there is an implied agreement.), paying taxes out of
partnership.
The Service is also looking at what happens after death,
even though they probably should not be considering after
death actions. He suggests paying taxes through a borrowing
arrangement with the partnership, rather then with a distribution
or even a redemption because there are valuation issues involved
there.
The bona fide sale exception. Do you have to have a bona
fide sale and full and adequate consideration?
In Stone, the children's attorneys had input into
the terms of the partnership agreement. This is consistent
with a commercial partnership.
There is no one fact that the courts have all hung their
hats on.
He reviewed an audit letter he received from the IRS and
suggests going through such letters as a way of thinking through
everything prior to creation of the entity.
Make sure your files show nontax reasons for setting up this
partnership.
Mentioned defined value clauses and noted that they just
filed the appeal in McCord on Monday.
More specifics will be discussed at the break-out session
tomorrow.
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