By Gary S. Burroughs, Richard S. LeVine and J. Ben Vernazza

Let us first dispel some notions as to whether you or a client should be a candidate for this planning strategy. How much net worth should one have to embrace asset protection planning? We will approach our response from the view of how much of your hard-earned assets are you willing to give up to a future creditor or frivolous lawsuit? The answer is not in a quantifiable dollar amount, but in terms of a percentage of assets that have been accumulated. For some may want to protect 100% of their asset base, but for others in might be less, or none at all. So an absolute dollar amount would not be the defining ;.”Cable.

The cost to establish and maintain this type of protective structure then becomes the issue. There are some international banks and attorneys that charge setup costs of $20,000 or more, while alternative providers will do the job for less than $7,000. Annual maintenance fees can range from $2,500 per year to upwards of 1½% of assets in trust per year.

Now let us get back to who are candidates for asset protection planning. There are two broad categories of prospects for asset protection planning. The first group are professionals: architects, attorneys, dentists, doctors, and of course CPAs. The second group includes everyone else.

As CPAs serving many clients during your career, you have a high risk of being sued for malpractice or of being a partner in a firm that is sued. The traditional professions (accounting, law, and medicine) face increasing exposure to plaintiffs' suits in tort. The crisis in accounting is perhaps the most recent. As Lee Burton described in the Wall Street Journal in 1995, legal liabilities associated with audit work have become truly staggering during the 1990's, at some firms consuming about 12 percent of total revenues, even after insurance reimbursement. In response to opportunistic lawsuits in the U.S., as well as more aggressive enforcement actions by bank, insurance and securities regulators against professional advisers, international lawyers have developed the use of tax neutral overseastrusts (an "overseas trust") to protect the assets of their U.S. clients. This article will describe how an overseas trust works and how it may benefit you or your clients.

Some of Your Clients Are at Risk!

Some of your clients are a walking bullseye for a predatory lawsuit. Here are a few examples, which are not in any specific order.

* Clients who produce/manufacture any product - including foodstuffs.

* Virtually any self employed professional
* Anyone involved in any way with a Year-2000 computer date failure
* Any client who flies a plane or has children who are driving.
* Any client where a family member or employee is a substance abuser.
* Any client who owns rental properties or contaminated land
* Any client who serves on a board of directors.
* Any client who has any employees or sub-contractors.

Do I Really Need This

The opening sentence of The National Law Journal's review of 1998 verdicts says it all: "Last year [1998] was a disastrous year for lawyers, accountants and other professionals involved as defendants in civil litigation." (Monday February 22, 1999, page C3). Here are a few of the more noteworthy verdicts against professionals and businesses during 1998.

Allard v. Arthur Andersen & Co., 601473 (Sup. Ct., New York Co.), jury award of $46 million in case where accounting firm was charged by bankruptcy trustee with failing to detect during audit substantial misappropriation of funds by corporate officers. Case settled while motions pending.

New South Investment Corp. v. KPMG Peat Marwick, L.L.P., 95-1940-GR (Cir. Ct. Montgomery Co., Ala.), $37 million jury verdict against accounting firm for negligence, fraud and intentional interference with a contract or business relationship. Plaintiff claimed audit report "created the appearance of insolvency … when the plaintiff was actively negotiating the sale of the company." The sale fell through and the companies went into receivership.

Kenney v. Bear, Stearns & Co., Inc., C-92-1845 (N.D. Calif.), $108 million verdict in case against investment banker for professional negligence. Plaintiff alleged that Bear Stearns had offered to provide financing for a transaction but failed to follow through, and that underfunding of transaction lead to bankruptcy of company

Why A Domestic Trust Is Inadequate

In most U.S. states, if a person places assets into a trust and retains the right to possibly receive distributions from the trust, then the assets in the trust will not be protected from the person's creditors. Some U.S. states have recently overturned that rule, and have enacted laws that extend spendthrift protection to the settlor of the trust. The problem with these so-called doJR}Ÿic asset protection trusts is that they are subject to the Full Faith and Credit Clause of the U.S. Constitution. So if a creditor gets a judgment against the settlor and convinces a judge in one U.S. state that the transfer of assets into the trust was a fraudulent conveyance (discussed further below), then the judge in the U.S. state where the domestic asset protection trust is located must respect the other state's judgment (so long as it meets a few very minimal procedural requirements under the U.S. Constitution) even if the law of the state where the trust is located would protect the settlor. For this reason, domestic asset protection trusts do not provide nearly the same level of protection, as do properly implemented "overseas trusts". Furthermore, lawyers in most other countries can't bring a suit on a contingency fee basis; the plaintiff has to pay cash up front for legal costs. In many countries other than the US, the losing party has to pay the legal costs of the winner. A bond must be posted in some cases. In most countries, a U.S. lawyer cannot represent clients before local courts even on a "one time only" basis, so the plaintiff must hire a local attorney. The burden of proof is on the creditor to prove a fraudulent transfer. Countries that are openly seeking to be asset protection havens generally have very short statute of limitations as compared to the U.S. All of these procedural rules are more favorable to defendants than the standard US rules.

Limited Liability Companies

The law in many states (including Oregon) provides that the sole remedy available to a creditor of a member of a limited liability company is to obtain a charging order against the member's interest. This means that while the creditor is entitled to receive whatever distributions would otherwise be made to the debtor/member, the creditor does not obtain any rights to management or voting rights in the company. So if the other the managers or the other members do not wish to declare any distributions at all, the creditor cannot compel a distribution and thus will not receive anything on account of its charging order. Many commentators think that the creditor's inability to directly access the assets inside the company will compel the creditor to settle any claim for a substantial discount. This may well be correct. However, there is little or no case law addressing this issue under any state limited liability company law, and none that addresses a limited liability company created primarily to protect assets from creditors. So the long-term strength of this protection is as yet untested. Moreover, being domestic entities a U.S. limited liability company is subject to the same procedural risks as are domestic trusts: long statutes of limitation, vulnerable to fraudulent conveyance attacks, subject to out of state judgment under U.S. Constitution, and availability of contingency fee plaintiffs lawyers. For all these reasons, the limited liability company offers far less protection than does the properly crafted overseas trust.

State Bankruptcy Exemptions

Many states pr e that a bankrupt individual can exclude certain istr property from the reach of creditors in a bankruptcy. For example, Florida provides in general that a person's home is exempt from creditors regardless of the value of the home. So if a person buys a very expensive home in Florida and resides there long enough before any claim arises (the purchase of the home is tested as a fraudulent conveyance), this can provide a nest egg relatively safe from most non-governmental creditors. Unfortunately, Oregon is not as generous with its exemptions (see chart). For many wealthy Oregonians it will be difficult to transfer major portions of their wealth into exempt assets within a reasonable time frame and at a reasonable cost.

Assets Not Available to Creditors in Oregon Bankruptcy

Up to $25,000 ($33,000 for joint owners) in value of homestead property

Bank deposits upto $7,500; wearing apparel, jewelry and other personal items to the value of $1,800

Insurance: Annuity contract benefits up to $500 /er month; life insurance proceeds or cash value if you are not the insured

Books, pictures and musical instruments up to $600; rifle or shotgun and one pistol to $1,000; burial plot; and, health aids

Up to $1,700 in value in a motor vehicle (auto, truck or trailer)

Up to $3,000 in value of tools, implements, apparatus, team, harness or professional library to carry on the trade or occupation of the debtor

Spousal support, child support, or separate maintenance to the extent reasonably necessary for the support of the debtor and any dependent of the debtor

Debtor's right to receive an award under any crime victim law; payments not to exceed $10,000 on account of personal bodily injury of the debtor or an individual of whom the debtor is a dependent; and a payment in compensation of loss of future earnings of the debtor, or debtors dependent

Debtor's interest in pensions or retirement plans including individual retirement accounts deposited greater than one year prior to attachment or filing; and, annuity contract benefits upto $250 per month

Currently Attractive Offshore Trust Situses

Common law jurisdictions which are currently viewed as having favorable asset protection trust legislation include:

A. Bahamas
B. Cook Islands
C. Gibraltar
D. Nevis
E. St. Vincent and the Grenadines

Why an Independent Trust Protector Is Needed

With an overseas (non-U.S.) trust, it is common for the settlor to appoint a Protector or Committee of Protectors. The Protector acts as an overseer of the overseas trustees in the exercise of their duties. Usually the Protector has the power to remove trustees, appoint trustees, change the venue (location) of the trust, approve the appointment by the trustee of an investment adviser, co-sign on accounts with the foreign trustee, etc. Also, the Protector has the right to obtain any information about the affairs of the trust or its companies from the trustees or officers.

The Protector is intended to reassure the client that some protection is available against a "runaway" trustee.

Although some trust formation services will tell your clients that the clients can serve as their own Protector, we are convinced that the Protector should be an unrelated person or company. With the trust grantor/settlor or even a related person as Protector, a foreign court could decide that the trust is a sham and that the trust really represents the "alter ego" of the settlor. . This same danger exists even if the protector is a close advisor to the grantor (or an employee) because the Protector could then be found to be so subordinate to the settlor that the Protector is merely an agent, nominee or alter ego of the settlor. This interpretation would be disastrous if a creditor of the grantor, even years after the formation of the trust, brought an action. The overseas courts could issue an order to the trustee to pay the 'legitimate claim' of the creditor. This result has a cataclysmic and unintended consequence notwithstanding the fact that there never was any fraudulent transfer -- just the fact that the courts have pierced the "trust veil."

This problem cand e avoided by appointing an independent protector company as the Protector (See the Sidebar on The Overseas Oversight Group). Another option is to appoint a committee of three Protectors to be appointed by the settlor: the client's unrelated lawyer, his unrelated tax adviser, and a professional overseas oversight company not located in the U.S. In the event of a potential creditor suit, the U.S. committee members would resign (preferably long before a judgment is issued), leaving the overseas Protector as the only overseer of the trustee.

How Can Client Retain Additional Control Before Trouble Comes Along

We generally do not recommend that the client retain substantial control over the trust or its assets at any time. However, we realize that some clients will not place assets in the trust without comfort that they have access to the funds prior to a major liability occurring. For these clients, the standard variation on the overseas trust is to have the trust become a 99% owner in a US limited partnership or limited liability company ("LLC") in which the client is the general partner or manager. In this way beneficial ownership remains in the foreign trust while control is in the hands of the client. When liability arises, the client can resign the control position and the trust can withdraw the assets from the US entity. The risk here is that the client will refuse to resign until it is too late. A US judge may order the client to turn over funds held by the partnership or LLC, or freeze transfers of assets held by the US entity, and the client will likely be held in contempt of court if it resigns or makes transfers after receiving such an order. We generally advise that the additional comfort from having control is not worth the risk that the overseas trust structure will fail to accomplish its primary purpose. For tax purposes, both the partnership and the overseas trust are "tax neutral". The tax attributes of the property flow from the partnership to the trust and then from the trust to the trust grantor.

Deciding Whether Is A Trust Foreign or Domestic for Tax Purposes

For tax years beginning after 1996, IRC section 7701(a)(30) provides objective tests to determine whether a trust is a domestic or foreign trust. Now, a trust is treated as a domestic trust if (1) a court in the U.S. can exercise primary supervision over the administration of the trust and (2) one or more U.S. persons have the authority to control all substantial decisions of the trust. If the trust does not meet both of these tests, it is treated as a foreign trust. If a trust satisfies these tests, it will not provide adequate asset protection, so that an overseas asset protection trust will almost always be a foreign trust. Section 679 of the tax code treats a foreign trust as being a grantor trust for US income tax purposes if (1) the settlor/transferor is a U.S. person and (2) the trust has one or more U.S. beneficiaries during any taxable year. Since the US grantor is traditionally among the beneficiaries of an overseas trust, these trusts will generally be grantor trusts for US income tax purposes regardless of the powers over the trust retained (or not retained) by the grantor.

Income Tax Compliance For the U.S. Grantor Of An Overseas Trust

*Trust grantor files Form 3520: o when a foreign trust is created

* when property is transferred to a foreign trust; or o after the death of a grantor of a foreign trust.

* Form 3520 is attached to the grantor's personal income tax return

* Grantor files Form 3520-A with the grantor's income tax return each year the trust continues to exist, whether or not additional transfers are made to the trust

* A U.S. beneficiary must also file form 3520-A each year a distribution is received from a foreign trust

* Grantor must file gift tax return and attach trust agreement even if transfer is not a completed gift

* Foreign trust must agree to appoint a limited "agent" for service of process by the IRS Foreign trust must provide the U.S. grantor or beneficiaries with the information they need to fulfill their tax reporting obligations.

* The details of the new reporting obligations are set forth in IRS notice 97-34. (Most of the content of that notice is included in the instructions to forms 3520 and 3520-A.)

Conclusion

In the U.S., a trust settlor generally can't be a beneficiary of a self-settled spendthrift trust, but that prohibition doesn't apply in all countries. An overseas trust can be a powerful tool to protect a nest egg of assets from predatory lawsuits and the settlor can be one of a group of beneficiaries of that trust. The trust settlor (grantor) should not be the trustee or even one of a group of trustees. While some overseas jurisdictions permit the trust settlor to be the trust protector, that's not recommended if asset protection is the primary goal. An independent protector or group of protectors should be appointed. The overseas asset protection trust is not a legal method of avoiding U.S. income or estate taxes except under limited circumstances. Hence, such trusts are arranged as "tax neutral" grantor trusts by U.S. persons.

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