If you have wealthy clients—especially ones who own a medical practice, real estate or another business that makes them potential targets for easy lawsuits—you might have considered an asset protection trust. It can be expensive, but is it effective? Do the trusts actually protect assets?

“Yes, they work,” says Daniel Rubin, a partner at Moses & Singer in New York and chair of its Trusts and Estates and Asset Protection Planning practice groups. They work particularly well for clients seeking protection from “the possibility of a future creditor, rather than an existing creditor or even an anticipated creditor,” he adds.

In other words, if there is already a claim against your client, or one is known to be in the offing, it may already be too late for an asset protection trust. Such transfers could be deemed fraudulent or “voidable,” says Rubin, and undone in court.

To be effective, asset protection trusts should be created in advance, not as an escape from known creditors.

Nothing New, Divorces Too
Conceptually, using trusts to protect assets isn’t new. Historians say they date back to ancient Roman law.

“They have always been part of estate planning and are incorporated into most estate plans,” says Andrew Bass, chief wealth officer at Telemus, an RIA firm in Southfield, Mich. He’s referring primarily to third-party trusts—often called “spendthrift trusts”—that do not benefit the grantor.

These trusts are, in essence, a way to take some assets off the table so that they’re difficult if not impossible for creditors to get at later. The process typically involves gifting assets into a trust for the benefit of heirs; the grantor (or settlor) is not a beneficiary. The trust is also irrevocable; assets moved into it are out of the grantor’s reach.

If operated properly, by an independent trustee, the irrevocable trust is “nearly impregnable by creditors or unintended beneficiaries,” says Bass. One reason for doing this might be to protect family property from claims made by an ex-spouse or descendants of an ex-spouse.

“Virtually all states allow an individual to establish a trust for the benefit of another individual and have the assets protected from creditors,” says Lawrence Richman, a partner at Neal, Gerber & Eisenberg in Chicago.

Self-Settled Trusts
In the 1980s, however, people began creating self-settled (as opposed to third-party) asset protection trusts—for which the grantor or settlor was a beneficiary—in offshore accounts. The Cook Islands, the Cayman Islands, Belize and other international tax havens became popular locations for what are called foreign asset protection trusts—largely because of their stringent privacy policies and high degree of anonymity.

These trusts are still used, particularly if the assets are located overseas. But they haven’t fared well when challenged in court. Foreign asset protection trusts “have resulted in 30 or so published opinions involving the settlor being sent to jail,” says Jay Adkisson, a partner at Adkisson Pitet in Las Vegas.

Domestic Asset Protection Trusts
Perhaps in reaction to the exodus of wealthy clients’ assets to offshore accounts, self-settled domestic asset protection trusts, or DAPTs, began appearing in the 1990s. The first was in Alaska, in 1997; less than three months later, Delaware followed suit, then others. At last count, 19 states supported these domestic trusts.

Like their third-party cousins, these trusts must be irrevocable; the grantor cannot alter the terms or have any power over the assets. The grantor can be a beneficiary, but all distributions are at the trustee’s discretion.

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