Salvation for Domestic Asset Protection Trust?

A Domestic Asset Protection Trust (DAPT) is a type of trust that allows you to protect assets that are held for your own benefit. These trusts are irrevocable and they have spendthrift provisions. That simply means that the assets held in a DAPT are not available to creditors of the beneficiaries (who, in this case, are also trust creators). There is one big problem with Domestic Asset Protection Trust. Namely, most states do not have statutes that allow for creditor protection or spendthrift provisions in self-settled trusts.

In other words, the law in most states is that if you create a trust for your own benefit, then assets held in the trust can be accessed by your creditors. For instance, California Probate Code section 15304 provides the following:

(a) If the settlor is a beneficiary of a trust created by the settlor and the settlor’s interest is subject to a provision restraining the voluntary or involuntary transfer of the settlor’s interest, the restraint is invalid against transferees or creditors of the settlor. The invalidity of the restraint on transfer does not affect the validity of the trust. (b) If the settlor is the beneficiary of a trust created by the settlor and the trust instrument provides that the trustee shall pay income or principal or both for the education or support of the beneficiary or gives the trustee discretion to determine the amount of income or principal or both to be paid to or for the benefit of the settlor, a transferee or creditor of the settlor may reach the maximum amount that the trustee could pay to or for the benefit of the settlor under the trust instrument, not exceeding the amount of the settlor’s proportionate contribution to the trust.

Asset protection laws in California, Texas, Florida, New York, and New Jersey do not provide protection for assets held in self-settled DAPT trusts.

Domestic Asset Protection Trust States

The laws of some states do, however, protect assets held in self-settled spendthrift DAPT trusts. These states include Tennessee, Ohio, Wyoming, Nevada, and Alaska. If you live in one of these states, then you can put your wealth into a DAPT to protect assets, so long as the creation and funding of the asset protection trust is not a fraudulent transfer. What if you don’t live in DAPT state? Can you still take advantage of the laws of states that offer domestic asset protection trust statutes? The answer is “maybe.” The problem is that laws of the state where you live typically apply to situations where creditors are trying to access your assets. Again, since most states don’t recognize DAPTs, in most cases you’ll be out of luck.

Getting DAPT Laws to Apply and Protect

There is one obvious way to get around this issue. One can simply move to the DAPT state where their asset protection plan was formed prior to the time when creditors attempt to execute on a judgment. In that case, it’s likely that a DAPT will be upheld. Another interesting theory is to create a domestic asset protection trust, place assets under the control of a trustee in the state with DAPT legislation, and create the DAPT with language that prohibits removal of the assets from the DAPT state.

This is an interesting concept that has yet to be tested in court. In a sense, this potentially gives domestic irrevocable trusts the same level of protection as offshore trusts. What’s clear is that assets in a non-DAPT state can’t readily be protected. In other words, if you own a house or have cash in a bank account in a non-DAPT state, the courts in the non-DAPT has jurisdiction over those assets and are very unlikely to apply rules in favor of asset protection.

A recent theory has been going around that if a creditor seeks to enforce a judgment against property located in a non-DAPT state (let’s say Texas), which is owned by a trustee in a DAPT state (e.g. Wyoming), the trustee could commence an action for a Declaratory Judgment in the DAPT state. In that scenario, if the trustee “wins first” (i.e. if the trustee obtains the Declaratory Judgment before the creditor can execute on the property in the non-DAPT state) , then the Declaratory Judgment can be domesticated in the non-DAPT jurisdiction. Then, under the Full Faith and Credit Clause of the U.S. Constitution, the non-DAPT state would be forced to honor the judgment.

Problems with Declaratory Judgments and DAPTs

There are two problems with this theory:

  • Lack of personal jurisdiction, and
  • Federal Anti-Injunction Act

First, in order to obtain a Declaratory Judgment in a DAPT state, the DAPT state itself would have to legally be able to exercise personal jurisdiction over the creditor. In many (if not most) cases, that will be easier said than done. Then, even if personal jurisdiction can be established, the creditor could make a motion to remove the case to Federal court, in which case 28 U.S.C. § 2283 would prevent any sort of declaratory judgment from being entered, as it provides:

A court of the United States may not grant an injunction to stay proceedings in a State court except as expressly authorized by Act of Congress, or where necessary in aid of its jurisdiction, or to protect or effectuate its judgments.

I’m aware of at least one case where section 2283 was successfully used by a creditor in an asset protection context. So the use of a Declaratory Judgment in this scenario isn’t really interesting, since there are too many problems with involving the creditor. What is interesting is the idea of using a declaratory judgment vis-a-vis the beneficiary of a DAPT and the trustee.

In other words, if the beneficiary (and creator) of a properly created trust institutes a declaratory action against his or her own trustee for a distribution of assets to the creditor in the DAPT state, then that declaratory judgment could potentially be domesticated in the non-DAPT state, which would keep the beneficiary (you) from a contempt of court finding and protect your assets.