A Foreign Asset Protection Trust (“FAP Trust”) trust is a trust located outside of the United States which is used to protect assets against creditor attacks. Under recent legislation, a foreign trust no longer offers any U.S. income tax advantages.
Purpose
The primary goal of using an offshore trust is to place property out of the reach of U.S. courts. This may be done by settling a trust in a jurisdiction that does not recognize or is reluctant to enforce U.S. judgments.
Formalities
The FAP Trust can be used to hold stocks, bonds, mutual funds, insurance, and annuity investments. A FAP Trust is established under the laws of a foreign country which provide certain advantages that cannot be achieved with a strictly domestic structure. Certain countries have laws much more favorable to asset protection than the United States. By creating a trust under the laws of one of these jurisdictions an individual can obtain greater protection and flexibility than is available under United States law.
In many ways, a FAP Trust looks like a standard domestic trust. All trusts have three essential parties:
- The Grantor, the person who transfers money or other property into the trust.
- The Trustee, the individual or a company that agrees to hold and manage the property for the benefit of the beneficiary.
- The Beneficiary, the person or persons who are entitled to the benefits of the trust.
In addition, to maintain a level of comfort in relation to the trust, the grantor may nominate a personal confidant as trust protector. Such a person may have the power to remove the trustee and to consult with the trustee regarding investment and distribution decisions.
The Trust Agreement is the written contract between the Grantor and the Trustee. The Agreement specifies in detail how the trust funds will be held and when and how the funds will be distributed to the Beneficiary. The law holds a Trustee to an extremely strict standard and severe civil and criminal penalties can be imposed for a violation of the Trustee’s responsibilities.
Trustee/Co-Trustee/Protector
The Grantor should not be in any of these positions, as this creates the possibility of the grantor being ordered by the courts to exercise the trust powers in a manner that would give to the grantor’s creditors, access to trust assets. It could also as well as lend support to the argument that the grantor has legal control over trust assets and administration, thus possibly constituting the trust a sham.
The trustee, trust protector or co-trustee should have no affiliation with the country of the grantor and beneficiaries if the anti-duress provisions (referred to below) in the trust instrument are expected to work effectively.
Discretionary Trust
A FAP Trust should always, if possible, conform to the irrevocable, discretionary trust model. This involves the transfer of property by the grantor to trustees on terms, that the trustees have absolute discretion as to the distribution of capital and income amongst a specified class (which may include the grantor’s spouse, children, and other family members) and the general investment and administration of the trust assets.
The principal characteristic of the discretionary trust is, that the beneficiaries have no vested interest in the trust property, but only an expectancy or the possibility of an interest that is not susceptible to attachment by a judgment creditor nor subject to the authority of a trustee-in-bankruptcy.
The grantor should have no beneficial interest in the trust other than a contingent reversionary interest, meaning that the corpus of the trust would only revert back to the grantor if a specified event occurred.
The Corpus of the Trust
The corpus of a FAP Trust should be limited to liquid assets (bank deposits, marketable securities, etc.). For example, a transfer of title to foreign real estate to a Bahamian trust is of little avail in an asset protection context since, under rules of Private International Law, the legal location of the property will govern.
Reserved Powers of the Grantor
In structuring a FAP Trust careful attention must be paid to identifying those powers that can safely be reserved to the grantor without running the risk of a trustee-in-bankruptcy succeeding to them or a court setting aside the trust on the footing that the grantor’s reserved powers are badges of fraud.
One of the more common reserved powers under a Bahamian trust, for example, is a limited power of appointment under which the grantor may by will (and by reference to the power reserved under the Trust) or by deed appoint the trust assets to a designated class of persons (from which he is excluded).
It is generally inadvisable in an asset protection context to vest the power to change beneficiaries directly in the grantor (unless the trust instrument expressly precludes the grantor from appointing himself as a substituted beneficiary) since a trustee-in-bankruptcy may succeed to it or, at the very least, be able to restrain the bankrupt from so exercising it as to defeat his creditors.
Anti-Duress Provision
Significant asset protection features are derived from the Anti-Duress provision of the Trust Agreement. The Anti-Duress provision states that if the grantor is ordered by a court or government agency to turn over an asset of the trust, the trustee will not and cannot comply. The trustee is under a duty to preserve trust assets and will not respond to orders of a court or orders issued by the Grantor under court compulsion. Since the trustee is outside of the jurisdiction of United States courts and the judgment cannot be enforced against the trustee, the asset will be safely protected.
Where the protector has the power to appoint the trustee, the trust instrument should state that the grantor, any beneficiary, or the protector may not be appointed trustee. The trusteeship should be entirely independent. The instrument should further state that no person from the jurisdiction of the grantor or beneficiary may be appointed as trustee, co-trustee, or trust protector and if such a person is appointed, the existing trustee may remove that person immediately.
Termination of Trust/Perpetuity
It is the usual practice that the trust instrument would give the trustee discretion to terminate the trust. Alternatively, there may be a fixed date of termination with the power to extend the trust period (within the perpetuity restrictions) given to the trustee in the event there is an outstanding judgment or other creditor action threatened near the fixed termination date.
The rule against perpetuities exists in several offshore jurisdictions and voids any disposition by which the absolute vesting of property may be postponed beyond the perpetuity period.
Spendthrift Provisions
Care should be exercised in drafting “spendthrift” provisions, where a beneficiary is limited as to what or how much the trust proceeds can be spent on, since such clauses are construed strictly and in the absence of unambiguous and specific language, will not prevail against a trustee-in-bankruptcy.
Flee Clause
This type of clause makes provision for changing the governing law and jurisdiction of the trust upon the happening of some adverse event, whereupon the existing trustees retire and automatically new trustees in a safe jurisdiction would replace them, thereby effecting a change in the governing law of the trust as well. This clause should state that the governing law and jurisdiction cannot be changed to that of the domicile of the grantor or any beneficiary under the trust.
IRS Reporting Requirements
The FAP trust is recognized as a grantor trust and is described in IRC Sections 678 and 679 of the Internal Revenue Code. At that time, IRS Forms 926 and 3520 must be filed with the IRS disclosing the formation of the Trust. In addition, if a U.S. person decides to have any signatory authority or other direct control over bank accounts with amounts more than $10,000, Form 90-22.1 must also be filed with the IRS. Typically, such direct control is not necessary since the foreign trustee will be sensitive to the requests of the grantor, which will be you. Also an annual return must be filed setting forth the income and activities of the trust. The stated purpose of the Act was to insure that individuals who use foreign trusts with overseas bank accounts fully report the income of the trust.
Tax Treatment of FAP Trusts
The FAP Trust is treated as a “Grantor Trust” meaning that property transferred to the FAP Trust is treated as “owned” by the grantor. Thus, all income gain and loss of the FAP Trust is reported directly on the grantor’s tax return. As a result, there are no income tax advantages to be achieved with the FAP Trust. The FAP Trust is not designed to offer any tax advantages; its objective is to provide creditor protection for one’s property.
A FAP Trust, however, may act as a conduit for money going offshore to grow tax-free in a “decontrolled environment” as explained elsewhere.
Selection of Jurisdiction
Selecting the proper jurisdiction for the FAP Trust is a matter of critical importance. As a rule, the jurisdiction should have well-established trust laws favorable to asset protection strategies. Further, it should be inconvenient or nearly impossible for a U.S. creditor to reach the assets of the trust by commencing an action in a foreign country. The factors which are most important are as follows:
- Ease of Communications
- Experienced and Well-Established Trustees
- No or Low Tax Jurisdiction
- Strict Bank Secrecy Laws
- Favorable Trust Laws
- Stable Local Government
- Favorable Asset Protection Laws
- Absence of Exchange or Currency Controls
- Confidentiality
Selection of Trustee and Advisors
Trustees and advisors are fiduciaries of the grantor and to the trust. Thus, they will carry out the wishes of the grantor and act in the best interests of the trust.
To avoid being subject to U.S. jurisdiction, the trustee of a foreign trustee should have no U.S. contacts and should be a nonresident alien or foreign corporation. Trust advisors, or a committee of advisors, if any, should be similarly selected.
Effectiveness of the Trust
A FAP Trust will be sustained when it is (i) carefully structured to comply with both the laws of the domicile of the grantor and the laws of the jurisdiction (ii) established at a time when there is no pending or potential creditor claims, (iii) the grantor has retained sufficient assets to meet any foreseeable creditor claims, (iv) the FAP Trust holds liquid assets and (v) the trustee has control over the trust and its assets. Essentially, the key to the success of a FAP Trust is that it should be the result of timely planning and not of impending disaster.
Another benefit of the FAP Trust is that it greatly raises the cost of pursuing a judgment by a future creditor. First, the foreign jurisdiction will require the creditor to file his claim in its courts, under its laws, using a lawyer authorized to practice in its jurisdiction.
In addition, contingent legal fees are not allowed in countries with laws that are favorable to the defendant. That means the plaintiff will have to pay cash to the foreign lawyers to pursue the case. In addition, travel expenses will have to be paid to the U.S. lawyers and any witnesses to pursue the case in the foreign jurisdiction. To make matters even worse, there are some foreign jurisdictions where the loser has to pay the legal costs of the winner and must post this sum with the court in advance of trial. These hurdles will generally eliminate all contingent fee claims by a plaintiff who is looking to take advantage of an exaggerated or spurious injury.
Limitations
There are limitations on the privacy or protection that a FAP Trust may provide. Depending on the way it is structured, the FAP Trust may be subject to discovery proceedings, such as in bankruptcy or criminal fraud proceedings.
In addition, it is critical to remember that a FAP Trust may not be established to defeat the claims of a client’s present creditors. In most offshore jurisdictions, the law requires that 1) the grantor not be insolvent when settling the trust, nor that the disposition render the grantor insolvent, and 2) the grantor must not form the trust with the intent to defraud a creditor. A FAP Trust may not be used when events have already occurred which may give rise to litigation and liability. For these reasons, it is important to establish a FAP Trust before any threat of such trouble arises.
Other Advantages of Creating a FAP Trust
Estate Planning
A FAP Trust may be used to preserve the continuity of a family business or the capital of the trust for several generations of beneficiaries. The so-called “spendthrift” provisions may be included in the trust instrument prohibiting the trustee from making any direct distribution to any beneficiary until the attainment of a certain age. The preservation of capital may be further advanced by the ability to accumulate undistributed income as capital for the duration of the trust.
A Probate Substitute
The use of a simple trust can obviate the often lengthy and costly probate procedures that might otherwise arise in the event of the grantor death. By constituting an inter vivos trust, the grantor transfers the legal ownership of his assets into the hands of a trustee and the administration of the assets will continue after his death with a smooth transition to his heirs. The avoidance of probate also maintains the confidentiality of the grantor offshore.
Privacy
Trusts are private agreements between parties and are not subject to public filing or disclosure. As an offshore trust subject to a foreign jurisdiction, the FAP trust offers that much more privacy for U.S. residents. Moreover, in some jurisdictions, such as the Bahamas, the grantor has the right to exclude even the beneficiary’s access to information regarding the trust.