Asset Protection Trust

An asset protection trust is an irrevocable trust of which the person who created it, the settlor, is also a permitted beneficiary, and whose governing law prevents the settlor's later creditors from reaching the trust property. The domestic version, often abbreviated DAPT, depends on a state statute that displaces the ordinary rule; the offshore version depends on a foreign jurisdiction's law and on the practical difficulty of enforcing a US judgment against a trustee outside the United States.

The name is a practitioner label, not a statutory one, and the difference matters when looking anything up. Wyoming's statute calls the device a qualified spendthrift trust and sets out its requirements at Wyoming Statute 4-10-510 and following. Nevada's whole chapter is headed Spendthrift Trusts, at Chapter 166 of the Nevada Revised Statutes. Neither uses the phrase "asset protection trust", and neither does any Treasury regulation or IRS document.

The background rule this is an exception to. A spendthrift provision stops a beneficiary's creditors from reaching the beneficiary's interest before it is paid out. It has never done anything for the person who created the trust: under the ordinary rule, a settlor's creditor can reach the maximum amount the trustee could distribute for the settlor's own benefit, whether or not the trust contains a spendthrift clause. That is the rule the statutes behind these trusts set aside, and it is why the arrangement is described as "self-settled": the settlor and a beneficiary are the same person.

What a state statute actually asks for. Wyoming Statute 4-10-510 requires a trust instrument that says it is a qualified spendthrift trust under that section, expressly adopts Wyoming law, contains a spendthrift provision described as "a restriction on the transfer of the settlor's beneficial interest ... enforceable under applicable nonbankruptcy law within the meaning of Section 541(c)(2) of the Bankruptcy Code," and is irrevocable. That last requirement is looser than it sounds. The same section lists powers the settlor may keep without the trust being treated as revocable, including a veto over distributions, a power of appointment, the receipt of income, the receipt each year of a stated percentage of the trust's value not exceeding five percent, discretionary distributions of principal made by a qualified trustee, and the right to remove and replace the trustee or a trust protector.

Wyoming Statute 4-10-517 then narrows what a creditor can do: a creditor of the settlor "has only those rights ... as are provided in W.S. 4-10-514 through 4-10-523," and must prove "by clear and convincing evidence that the transfer of property to the trust was a fraudulent transfer" under the Uniform Fraudulent Transfers Act. The section adds a detail worth noticing: proof by one creditor that a transfer was fraudulent "does not constitute proof as to any other creditor," so each claimant starts over.

Nevada shows the other half of the design, which is timing. Nevada Revised Statute 166.170 gives a person who was already a creditor when the transfer was made two years from the transfer, or six months from discovering it, whichever is later. Someone who becomes a creditor afterward has two years from the transfer and nothing more. Subsection 2 treats a public record of the transfer as discovery, and subsection 3 requires clear and convincing evidence either that the transfer was fraudulent under Nevada's fraudulent-transfer chapter or that it violated a legal obligation the settlor owed the creditor under a contract or an enforceable court order.

Nevada attaches two structural conditions as well. Under NRS 166.040(1)(b), a spendthrift trust may be created for the settlor's own benefit only where the writing "is irrevocable, does not require that any part of the income or principal of the trust be distributed to the settlor, and was not intended to hinder, delay or defraud known creditors." And under NRS 166.015, if the settlor is a beneficiary, at least one trustee must be a natural person resident and domiciled in Nevada, a trust company maintaining a Nevada office, or a bank with a Nevada office that possesses and exercises trust powers. A trust of this kind is therefore not a document that can be signed and forgotten; it requires a trustee in the state, indefinitely.

The federal overlay, and the sentence that is usually mis-stated. Section 548(e)(1) of the Bankruptcy Code lets a bankruptcy trustee avoid a transfer made within ten years before the petition, which is far longer than any state deadline. It is routinely described as a flat ten-year clawback on these trusts. It is not. The provision requires all four of its elements: the transfer was to "a self-settled trust or similar device", it was made by the debtor, the debtor is a beneficiary of the trust, and the debtor made it "with actual intent to hinder, delay, or defraud" a creditor. Element (D) is where the contest happens. Subsection (e)(2) then widens what counts as a transfer for this purpose, so that it "includes a transfer made in anticipation of any money judgment, settlement, civil penalty, equitable order, or criminal fine" the debtor incurred or believed would be incurred from a securities-law violation, or from fraud, deceit or manipulation in a fiduciary capacity or in connection with the purchase or sale of a registered security.

The unresolved question the marketing rarely raises. These statutes are state law, and the person a creditor is suing usually lives somewhere else. A court in the settlor's home state, applying its own public policy to a resident's transfer of local property, may not defer to another state's statute. That conflict is real, it is litigated, and it means the protection a domestic trust actually delivers depends on where the eventual lawsuit is brought, not only on how the document was drafted.

Offshore trusts change the enforcement question rather than the legal one. The appeal of a foreign trustee is jurisdictional: a US court has no power to order a trustee it cannot reach. But it does have power over the settlor, who is normally still in the United States, and the natural response to an unproduced asset is an order directed at that person. Two further costs are certain rather than contingent. The arrangement is expensive to establish and maintain, and a US owner of a foreign trust carries annual reporting obligations, on Form 3520, "Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts," and on Form 3520-A, "Annual Information Return of Foreign Trust With a U.S. Owner." Neither form reduces any tax; both carry penalties for being late.

The mechanics, and then the two clocks that decide whether it works.

1. Choose a jurisdiction whose statute permits it, and read what that statute requires rather than what the label suggests.

2. Draft to the statute exactly. Wyoming, for instance, requires the instrument to declare itself a qualified spendthrift trust, to adopt Wyoming law expressly, to carry a spendthrift provision in the statutory form, and to be irrevocable.

3. Appoint a qualified trustee. Where the settlor is a beneficiary, Nevada requires at least one trustee in the state, and Wyoming's protection runs through its own qualified-trustee requirement.

4. Transfer the property while nothing is pending. Both statutes read here turn on whether the transfer was fraudulent as to a creditor, and both start their clocks at the date of the transfer.

5. Keep the arrangement genuine. Retaining powers the statute permits is fine; treating the trust as a personal account is what invites a court to disregard it.

A hypothetical showing the two clocks. In March of year one, Dr. Okafor transfers $2,000,000 to a Nevada trust drafted under Chapter 166, with a Nevada trust company as trustee. She has no claims against her and knows of none.

In year four a patient treated in year three sues her. That person became a creditor after the transfer, so under NRS 166.170(1)(b) any action against the trust property had to be brought within two years of the transfer, a window that closed in March of year three. The $2,000,000 is out of reach of that claim.

Now change one fact. Suppose the patient had already filed suit in February of year one, a month before the transfer. That person was a creditor when the transfer was made, so the deadline is the later of two years from the transfer or six months from discovery, and the transfer itself now looks like exactly what the fraudulent-transfer rules exist to catch.

And add a third layer. If Dr. Okafor files for bankruptcy in year eight, the bankruptcy trustee may reach back ten years under section 548(e), but only by establishing all four elements, including that she made the transfer with actual intent to hinder, delay or defraud a creditor. On the first set of facts that would be a difficult case; on the second it would not be.

Pros

• In a state whose statute allows it, the settlor may benefit from the trust while future creditors are limited to the narrow route the statute leaves open.
• The evidentiary bar is high where these statutes apply: clear and convincing proof of a fraudulent transfer, rather than the ordinary civil standard.
• The deadlines are short and run from the transfer, so property transferred well before any claim arises becomes progressively harder to reach.
• The statutes permit the settlor to keep meaningful powers, including a veto over distributions, a limited power of appointment and the right to replace the trustee, without the trust being treated as revocable.
• Wyoming allows an existing irrevocable trust to elect into qualified spendthrift status, with protection running from the election date.

Cons

• It does nothing against a creditor who already exists or a claim already in view. Those are the transfers the fraudulent-transfer rules are written for.
• Bankruptcy applies a ten-year reach-back under section 548(e), far longer than any state deadline, where its four elements are met.
• Whether a court in the settlor's own state will apply another state's statute to a resident's transfer is genuinely unsettled, so the protection is not as portable as the drafting suggests.
• It requires a trustee in the chosen state, permanently, with fees for as long as the trust exists.
• The property is really given away. Distributions back to the settlor are at a trustee's discretion, and behaving as though the money is still personal is what gets these arrangements set aside.
• An offshore version adds annual Form 3520 and Form 3520-A reporting, real penalties for late filing, and the possibility that a court will simply direct its orders at the settlor rather than at the trustee.