Introduction

In the United States, there has been a malpractice crisis for the medical profession for a number of years. It has at its roots the American Trial Lawyers who advocate a position that the medical profession is not adequately regulated for physicians whose practice causes harm to their clients. Its associations vigorously contend that victims of malpractice by physicians are inadequately compensated from injury and demand that no limits can be imposed as to the amounts mandated by the jury. The insurance underwriters of medical professionals assert that large verdicts have caused them to raise premiums where they depart from economic reality. When a physician factors in the cost of insurance in terms of doing business, the risk-reward analysis in specific instances does not always result in a rational result.

In many instances, some physicians find that they are no longer able to carry sufficient coverage. The coverage they do carry many times is inadequate to protect their personal assets. A physician could be carrying coverage for a $10 million dollar limit of liability, only to have a verdict rendered which greatly exceeds that coverage. Their personal assets then become the target of enforcing the balance of an unpaid judgment. The same can be said for every individual who owns an automobile, and most individuals with substantial insurance coverage still remain open to this exposure. The negligence awards returned often greatly exceed an individual’s coverage. These examples illustrate but a few instances where Asset Protection Trusts make a lot of sense.

United States Case Law – Asset Protection Trusts

In the United States, legal professionals have sought for years to draft the requisite Asset Protection Trust for their clients utilizing the case law precedents established in their particular jurisdiction. Case law precedents vary from state to state, and it is common to draw upon select and important case concepts to formulate such an instrument. They offer no certainty in the United States because, though a case may be precedent, it can technically be viewed as only applicable to the precise factual setting that it was decided upon. A judge that does not desire to follow the precedent can find a factual distinction and thereby avoid applying the relied upon case. Where there is a statute, there is certainty that is subject to a court’s interpretation. Where there is case law, it defines a general path but with no certainty.

The typical individual does not want to relinquish control over their assets. Yet not even irrevocable transfers to a domestic trust and to independent parties as trustees provide any absolute predictability. On the one hand, the individual desires to retain a right to discretionary distributions of income and/or trust corpus. On the other hand, the predictability is predicated upon a relinquishment of those rights in a hedged fashion. Because of the complexity of these issues pertaining to non-statutory Asset Protection Trusts based upon case law precedent of United States state case law, this writing adheres to a few basic observations to enable the reader to grasp the dilemma.

There are three basic references to use in drafting an Asset Protection Trust in the United States: established case law in a particular state, state statutory law that a number of states have established of recent, and the offshore statutes provided by Financial Havens. Using state case law concepts developed by previous precedent, one is confronted by cases and concepts that vary greatly. But perhaps the most logical manner to gain an understanding is to think in terms of two diametrically opposed spectrums. At one end of the spectrum, the Settlor finds the more secure position from creditors by relinquishing control of the income and corpus of the assets transferred to trust. At the other end, the Settlor desires to make irrevocable transfers but retain various aspects of control.

There is no safer harbor to assure an individual in crafting these documents and meeting one’s desires as there is with a statute for guidance. There are additional considerations of gift tax issues if there is a release of dominion and control of corpus and income. The review of several United States cases is helpful to more fully appreciate the uncertainty and differences between a Financial Haven’s Asset Protection Trust legislation and the United States domestic Asset Protection Trust that is reliant upon case precedent.

There are two state cases that provide some insight and guidance. In the California case, Dimaria v. Bank of California (1) the court importantly distinguished the trust from a spendthrift trust or a fully discretionary trust. In Dimaria, a widow executed an irrevocable trust agreement and transferred her assets to a bank acting as the trustee. The terms of the trust document stated the income of the trust was payable to the Settlor during her lifetime, and the corpus remaining at her death was to be paid to her two children. The children were over 21 years of age at the time the trust document was executed.

The independent trustee was provided discretionary power to apply trust corpus for the benefit of the Settlor in such amount as the trustee deemed advisable. The document provided guidance to the trustee in exercising this discretion over the corpus distributions for the Settlor’s benefit. It stated corpus distributions were to be made in the trustee’s discretion. That discretion was provided guidance by the trust document. It stated the corpus distributions were only to be made if the trustee determined the trust income, along with the Settlor’s own assets that generated income, was insufficient to provide reasonable support, medical care, and comfort. It provided a standard to guide the trustee.

A judgment creditor attempted to attach the trust corpus. The court denied the creditor, basing its finding upon the premise that to allow the creditor rights to corpus was to give the creditor greater rights under the terms of the trust document than the beneficiary was granted. Additionally, the court found that because the trust corpus passed to the Settlor’s children upon her demise, the children possessed a vested remainder in the trust corpus that could not be defeated by creditors. Note the claim was upon the trust corpus; the trust income may be subject to claims.

A second case demonstrating these techniques used by practitioners is the case of Estate of German. (2) It was heard in a tax court forum, but the substantive law of the state of Maryland was the court’s non-tax law guidance on certain salient issues. Irrevocable trusts were created for the benefit of Settlor’s two children, and the children were co-trustees.

The terms of the trust document provided that the trustees could accumulate trust net income and add it to trust corpus at each year’s end. Upon Settlor’s death, the trust estate was to continue to be held for the benefit of the two children and their families. During Settlor’s lifetime, the trustees at any time in their absolute and uncontrolled discretion had the power to pay to or apply for the Settlor’s benefit all or part of the net trust income and principal. However, such distributions required the written consent of the trust beneficiary of each trust from which funds were to be distributed. The court found the trust document to prevent the attachment by any creditor of Settlor. The case at issue in the United States Federal Claims Court was whether a completed gift had been made and whether gift tax was due, and this substantive trust law was visited.

In summary, observe the two ends of the spectrum. At one end, there is the Settlor who does not want to transfer assets beyond his or her ability to have the assurance of their use. At the other end of the spectrum note the extent of the power over income and corpus that must be relinquished by a Settlor to accomplish defeating a claim of a future creditor. The crafting of these documents must adhere to state law interpretation of substantive trust law, but also as importantly, the combination of federal estate and gift tax law applicable. These documents are very individualized and require retention of a certain element of dominion and control by the Settlor to prevent a taxable gift, yet meander from the judgment creditor. (3)

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Footnotes

1. 237 Cal. App. 2d 254, 46 Cal. Rptr. 924 (1965).

2. 85-1 USTC Par. 13,610, 55 AFTR 2d 85-1577 (Ct. Cls., 1985).

3. A gift is deemed to be incomplete if and to the extent that a power reserved gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard. See Treas. Reg. Section 25.2511-2(c). That is, where a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift. See Treas. Reg. Section 25.2511-2 (b). It is the crafting of this specific federal tax concept with the substantive state law of trusts from which the appropriate objective is derived. Note generally Section 2031 IRC of 1986 and federal estate tax component.

In accordance with Circular 230 Disclosure