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.

Case Law
Since not all states support domestic asset protection trusts, lawsuits have challenged the validity of those in which the grantor or the assets don’t reside in the state where the trust was established. For example, in 2018, in a case known as Toni 1 Trust v. Wacker, two Montana families were tied up in litigation when one of them sought to shield assets by transferring them to a trust in Alaska. The courts ultimately nullified the trust, declaring the transfers fraudulent since they were made solely to avoid an existing obligation.

Similarly, in Waldron v. Huber, the owner of a real estate investment and development concern in Washington state created a domestic asset protection trust in Alaska to shield his assets from debt obligations he couldn’t meet. The court again found that the trust was a fraudulent transfer of assets made with the intent of avoiding already established creditors.

“Technically, these were bankruptcy and fraudulent transfer cases, not choice-of-law cases,” says Steven Oshins, managing partner at Oshins & Associates in Las Vegas. There still hasn’t been a case where a domestic asset protection trust lost because of a legal issue, he says.

Jeffrey Lauterbach, a family office consultant in Chadds Ford, Pa., agrees. “The little bit of case law that exists primarily concerns people doing a bad job of planning—putting all their money in the trust when they knew they had claims against them,” he says.

Still, if your client or client’s assets are in a state that doesn’t support domestic asset protection trusts, Lauterbach suggests making sure the trustee does reside in the state where the trust is established.

Hybrid Trusts
To avoid such potential complications, Oshins often recommends a hybrid version of the domestic asset protection trust. It’s like a third-party spendthrift trust—not self-settled, meaning the grantor is not a beneficiary. The difference is, the trustee can add beneficiaries, including the grantor, later on, at which point it reverts to a regular DAPT.

A Patchwork Of State Laws
If a client’s state doesn’t support domestic asset protection trusts, it might pay to shop around. Each state that allows the trusts has different rules. “Nevada and South Dakota are regularly ranked as the most supportive of protecting assets, with statutes designed to provide maximum protection,” says Steven Skancke, chief economic advisor at Keel Point in Washington, D.C.

Some no-income-tax states exempt earnings on DAPT assets from state income taxes, while others specifically do not. “Most states don’t protect against child support awards,” says Eva Victor, senior vice president and director of wealth planning at Girard, a Univest Wealth division in King of Prussia, Pa.

Moreover, most states have a three- or four-year statute of limitations before establishing protection of assets in the trust, though Nevada’s waiting period is just two years. “This gives Nevada a leg up when marketing DAPTs,” says David Work, managing director of estate and financial planning at Hightower in Dallas.

Keep Some Assets Outside The Trust
Whatever the merits of asset protection trusts, it’s a good idea to keep some assets outside of them. Trust assets are out of reach, after all, and your client will need other funds to live on in retirement.

Keeping some assets separate is also essential for establishing the trust’s validity. “Attorneys who do this work have developed a set of best practices,” says Lauterbach, the family office consultant. “Many of them require an affidavit of financial solvency from the client to demonstrate or at least claim that they can support themselves independently of the trust.”

Ultimately, asset protection trusts are just part of “building a strong liability shield,” says Mallon FitzPatrick, a managing director and principal at Robertson Stephens in San Francisco. A combination of liability insurance, a limited liability company (LLC) or family limited partnership (FLP), and an asset protection trust is often best. “Layering an LLC inside the asset protection trust further shields the assets,” he says.