One of the hot topics among planners over the last several years has been how to utilize the laws enacted by several states (now five) allowing a person to create his own self settled trust or domestic asset protection trust (called a “DAPT”), which have been promoted as not reachable by creditors, if they satisfy the elements of the particular state statue. In this type of trust, the client transfers his own assets to a Trust in which he is a beneficiary and, while trying to get the best of all worlds, remains a beneficiary of his own assets, but prevents creditors from reaching those assets if financial times turn south on him. Clients also have utilized the laws of foreign jurisdictions such as Bermuda, Cayman Islands and other offshore havens which were friendly to debtors and not so to creditors to try to achieve these same goals with mixed success. A recent case in the Bankruptcy Court for the District of Alaska, one of the five states having such favorable legislation, has raised a real question of whether these DAPTs will work, especially if a bankruptcy is involved.
In Battley v. Mortensen, an Alaskan resident who was solvent at the time, set up his own DAPT, which was for his own benefit as well as his children. Subsequently he fell into hard times and filed for bankruptcy protection within the 10 year clawback period under the applicable Federal Bankruptcy Code provisions. The Bankruptcy Trustee successfully attacked the trust on behalf of creditors and was able to reach the assets. Battley claimed under Alaska law that the Trust met all the safe harbors rules, including that it was not created to hinder, delay or defraud creditors as he was solvent at the time it was created. The Bankruptcy Court did not agree, however, and held that the Federal Bankruptcy law superseded Alaska law, which had a 4 year clawback period. The Court’s view was that one of the purposes for a person to create one of these types of DAPTs was to do exactly that, i.e. to hinder, delay or defraud creditors at some time in the future, even though they were solvent at the time such Trust was created. The case was ultimately settled and therefore will not be appealed. Where the law goes from here is only a matter of speculation and time as this favorable result will clearly spur creditors to challenge these types of trusts in order to try to reach their assets.
Why does this matter to a Virginia resident? There have been groups advocating for similar legislation to be passed in Virginia in order to be on parity with these other states. Also, some advisors have recommended Virginia residents create a DAPT under the laws of the one of the states which has this favorable legislation, attempting to create enough nexus with that other state to have their trust governed by that state’s favorable laws. The question of what is sufficient to create that nexus has always been an open question, especially in current times, with each respective state trying to generate more revenues, through taxes and applying its own laws to reach such income. If there is not sufficient nexus, there is an additional risk that the trust may not be recognized under the other state’s laws.
So does this mean that a client should not utilize DAPTs? One must remember that the Mortensen case involved a bankruptcy within the 10 year clawback period under the Bankruptcy Code. If there had been no bankruptcy, there may have been a different result. A client needs to realize that if he elects to utilize one of these Trusts, he must have the risk tolerance of operating in a world where the rules are uncertain and sometimes develop after the fact in ways which may be substantially different than assumed under his plans. However, there still remain other alternatives for Virginia residents to consider. These include trusts set up by parents or other third parties for the person to be protected, transfers to spouses, joint tenancies, transfers to trusts for children and the use of LLCs and other entities to protect the assets from claims of creditors. If the Mortensen case remains good law (which clearly is not known at this point), it appears that there still may be no such a thing as a free lunch. –James G. Steiger