Offshore asset protection trusts offer a way to place your assets beyond the reach of creditors. However, these trusts must be carefully established and managed to avoid difficulties with the Internal Revenue Service.
An offshore asset protection trust represents an alternative to a domestic asset protection trust. Prior to 1997 and the enactment of new trust legislation in Delaware and Alaska, the offshore asset protection trust was the only real way to create an effective self-settled spendthrift trust.
Popular offshore jurisdictions for these trusts include Nevis, St. Kitts, the Cook Islands and the Bahamas. These jurisdictions have long recognized the validity of self-settled asset protection trusts.
As with their domestic counterparts, self-settled offshore asset protection trusts must:
- be irrevocable
- have an independent trustee
- provide only for distributions that are subject to the discretion of the trustee
- have a spendthrift clause
However, offshore asset protection trusts can offer significant advantages over domestic asset protection trusts.
You need to be aware that offshore tax shelters are prime targets of the IRS's stepped up campaign to discover unreported taxable income. Therefore, exercise extreme caution and consult a professional advisor before considering the use of an offshore trust.
While the laws differ in each offshore jurisdiction, the trust statute of the country of Nevis is illustrative of these advantages. Nevis law provides that an asset transfer can be challenged only by factually proving actual fraud. The broader grounds available to attack a transfer to a trust in Delaware are not available in Nevis. In this respect, the law in Nevis is similar to that found in the Alaska trust statute. However, Nevis places significant restrictions on the rights of a creditor that do not exist in Alaska or Delaware.
The general statute of limitations in Nevis for challenging transfers to the trust is two years, rather than the four years available in Alaska and Delaware.
Nevis will not recognize a foreign judgment. Instead, the creditor must file a new lawsuit in Nevis and prove actual fraud in the new case there. Further, the creditor must hire a Nevis-licensed attorney, and post a $25,000 bond to bring the suit. In contrast, in the United States, every state is compelled by the U.S. Constitution to recognize a sister state's judgment under the Full Faith and Credit Clause.
The fact that no international law compels a sovereign nation to accept the laws of a foreign government really represents the essence of an offshore asset protection trust: The offshore jurisdiction is simply immune from U.S. laws. While the trustor/beneficiary will be a resident of a U.S. state, and thus subject to U.S. court jurisdiction, the trustor/beneficiary cannot compel the offshore trustee to make a distribution, because all distributions are subject to the trustee's discretion. Thus, when a U.S. court orders the trustor/beneficiary to compel a distribution, the trustor/beneficiary can invoke what is termed the "impossibility" defense because of certain clauses contained in the trust. Until recently, this defense has been successful.
Moreover, once the new required lawsuit is filed in Nevis, the creditor must prove actual fraud by a "beyond a reasonable doubt" standard. In the United States, this standard applies only in criminal cases. It equates to the creditor establishing there is a more than 90 percent probability that his or her allegations are true.
By contrast, in the U.S., the standard to win in a civil case by a creditor challenging an asset transfer is proof by a "preponderance of the evidence." This standard is much lower; the creditor needs only to establish that there is a more than a 50 percent probability that the allegations are true.
The intent of the U.S. criminal standard is to prevent, to the greatest extent possible, innocent people from being convicted of crimes they did not commit. The standard is based on the theory that it's better to let nine guilty people go free, than to convict one innocent person.
To achieve that effect, it is acknowledged that the use of such a high standard also may serve to protect guilty persons. This is part of the cost of protecting the rights and liberty of innocent persons. The use of this standard in a Nevis offshore trust case will make it extremely difficult for a creditor to prevail in a claim.
Foreign jurisdictions do not require that any of the trust's assets be located there. This is in contrast to the Delaware and Alaska trust laws, which require that at least some assets (perhaps a bank account) be located there.
Careful drafting helps ensure offshore trust validity
Typically, offshore asset protection trusts will contain the following clauses in addition to a spendthrift clause.
Anti-Duress Clause. This clause, when triggered, provides that the trustee is not to make a distribution from the trust when the trustor/beneficiary is under "duress" —that is, when a creditor has made a claim, or obtained a judgment against the trustor/beneficiary, outside of the foreign jurisdiction.
This clause effectively prevents the creditor from enforcing the claim against the trust's assets without obtaining a new judgment in the offshore jurisdiction, as a result of a new lawsuit that was filed there. When this clause is invoked, it automatically removes the trustor/beneficiary from the positions of trust protector or co-trustee, if he or she held such positions. See below for the definition of trust protector.
Trust Protector Clause. This clause names a "trust protector" and allows him or her to remove the trustee and, in some cases, to veto some or all of the trustee's actions. The trust protector is a very useful concept derived from British law, which is one reason that former British colonies are among the more popular locations for offshore trusts.
In many offshore trusts, the trustor/beneficiary is the trust protector. When this is the case, usually the anti-duress clause (see above) also will trigger removal of the trust protector, when the trustor/beneficiary is under duress from a U.S. court. As discussed in the example below, it may be desirable to have an independent trust protector.
Flight Clause. This clause allows the trustee to move the site of the trust to another jurisdiction. In theory, this might be used if the creditor hired a local attorney and filed suit in the foreign jurisdiction. The suit could be thwarted by removing the trust to another foreign jurisdiction, so that the creditor would have to start anew by filing suit yet again in the new jurisdiction.
Choice of Law Clause. This clause directs that the trust is to be governed by the laws of the jurisdiction in which it is sited. While not necessarily conclusive on the issue of jurisdiction, such a clause is recommended. In addition, it is wise to:
- Avoid being the trust protector or a co-trustee of the trust. Ideally, the trust protector (or a co-trustee if this is used) should be someone outside of the U.S. court's jurisdiction. A U.S. person may be acceptable, provided this person is not the trustor/beneficiary and is, in reality, independent of the trustor/beneficiary. By doing this, the trustor/beneficiary will be laying the groundwork for a finding that he or she did not have the ability to control the trust and thus his or her ability to force a distribution from the trust was impossible.
- Avoid personally notifying the foreign trustee of a U.S. court judgment. Let the judgment creditor or the court notify the trustee. In this way, the trustor/beneficiary cannot be accused of personally triggering the anti-duress clause.
- Avoid engaging in fraudulent or disputable conduct. Courts are likely to display extreme hostility toward a trustor/beneficiary who is either trying to shield assets that were acquired through illegal conduct, or where the trust's assets were legitimately acquired, but the creditor's claim is based on illegal conduct on the part of the trustor/beneficiary.
Remember U.S. courts can assert jurisdiction over any property actually located within the United States, so caution must be exercised to ensure that none of the assets acquired by the trust are located within U.S. borders. Therefore, ownership by the offshore trust of real estate located in the U.S. would be the worst possible choice.
However, ownership of stock in U.S. companies also could present a problem. This risk might be avoided if the stock certificates are not held in "street name"--that is, they are not held by a U.S. broker. Instead, the certificates should be physically held by the trustee, in the trustee's name, in the offshore jurisdiction.
It is still possible, if the ownership is discovered, that the interest could be attached, as the obligation to honor the stock certificate emanates from a U.S. company. Luckily, many foreign jurisdictions also have secrecy laws that would make it difficult for the trust's actual investments to be uncovered.
In short, while offshore trusts may provide planning opportunities, this option must be cautiously approached.
Offshore trusts may have tax impact
Generally, the offshore asset protection trust will be deemed to be a "foreign grantor trust." The trust will be deemed a grantor trust because there will be a U.S. beneficiary. This status means that the contributions to the trust will be free of income tax consequences.
Such contributions will reduce your unified estate/gift tax exemption, unless you take advantage of the annual gift tax exclusion. See our discussion regarding this issue and domestic asset protection trusts.
This status also means that the trust's income will be taxed to you as the trustor/beneficiary, and you can report it on your personal income tax return, Form 1040. This will serve to simplify the reporting of the trust's income.
Remember, a U.S. resident is taxed on all worldwide income. Further, as discussed above, when an offshore trust has a U.S. beneficiary, the trust will be deemed a grantor trust, which means that the trustor/beneficiary will be taxed on all of the trust's income even if the income is not distributed, as if the income were earned directly by the trustor/beneficiary.
Representations that an offshore trust is an effective means for a U.S. resident beneficiary to avoid U.S. income tax are false and misleading.
Given the nature of the offshore trusts' provisions, its assets should normally be excluded from the estate of the trustor/beneficiary. This result is identical to that of the domestic asset protection trusts.
That the trust will be a foreign trust has certain implications. As long as the foreign trust has a U.S. beneficiary, the income tax consequences will be as described above. However, upon the death of the U.S. beneficiary, the trust's assets will be deemed to have been contributed to a foreign trust without a U.S. beneficiary. The result will be that all of the appreciation in the value of the trust's assets, since the assets were first purchased by the trustor, will be treated as taxable gain.
While the law in this area is not settled, it may be possible to avoid this outcome by requiring that the trust distribute all of its assets to a U.S. beneficiary upon the trustor/beneficiary's death or, of course, if there is another surviving U.S. discretionary beneficiary of the trust.
This result also would be avoided if the foreign trust were deemed to be a domestic trust. This result seems contradictory, but is a possibility under the federal tax code.
The Internal Revenue Code provides an objective test to determine when an offshore trust will be deemed, for tax purposes, to be a domestic trust. Basically, the trust must consent to the U.S. courts' having primary jurisdiction over the trust and to primary control by a U.S.-based trustee. Complying with either of these requirements means that the very purpose for which the offshore trust is designed (i.e., asset protection) will no longer exist.
Similarly, a safe harbor exists to qualify the trust as domestic. Among other things, the safe harbor requires that the trust not have a flight clause. A flight clause is a standard, as well as a desirable, feature of an offshore trust.
In short, qualifying the offshore trust as domestic usually will not be advisable. However, you should discuss this issue with the attorney who will be drafting the trust.
Consider these key trust planning issues
The offshore asset protection trust shares certain characteristics with domestic asset protection trusts. Thus, if you're thinking of setting up such a trust, you must carefully consider the irrevocable and discretionary nature of the trust.
However, the offshore trust has unique characteristics not found in domestic asset protection trusts. Thus, political stability, the financial strength of the foreign trust company, foreign currency gains and losses, and additional drafting costs are other issues that must be considered when examining an offshore trust as an asset protection strategy.
Offshore jurisdictions in which these trusts are commonly established have developed reputations as safe places to invest assets. However, some small business owners may be uncomfortable with the idea of placing investments outside of the U.S.
Legal fees for drafting an offshore trust can be expensive--more expensive than fees incurred for a domestic asset protection trust. The added fees must be weighed against the greater protection that potentially can be achieved with an offshore trust.
Also, ongoing maintenance fees payable to the offshore trust company can be substantial. These fees, combined with the initial setup fees, usually mean it is not cost-effective to establish an offshore trust until you have $1 million or more that you need to shelter.
In summary, each of these strategies involves its own unique risks. These risks, and the cost of setting up the trust, must be weighed against the potential benefits. The best way to do this is through consultation with an attorney who practices in this specialty.