Under the laws of some states, you can create and fund a trust for your own benefit that your creditors, theoretically, cannot invade. These are often referred to as "self-settled asset protection trusts." If you are a family business owner, a self-settled asset protection trust may be a prudent way to protect some of your investments and other assets that you own apart from your family business interests, in case you incur personal liability arising out of your involvement in the family business.
What is a Self-Settled Asset Protection Trust?
Under traditional trust law, if you create an irrevocable trust for a beneficiary other than yourself and if the trust contains special provisions that limit the beneficiary's ability to withdraw trust assets or convey his or her beneficial interest, then the beneficiary's creditors cannot invade the trust to satisfy the beneficiary's obligations (except with regard to some specific instances in family law). Often, this type of trust is called a "spendthrift trust."
Under the laws of most states, however, you cannot create a spendthrift trust for yourself. In fact, until about 20 years ago, if you wanted to protect your assets by placing them in a trust for yourself, you would have had to settle the trust under the laws of a foreign jurisdiction, such as Cayman Islands or Cook Islands or the Isle of Man. An offshore asset protection trust can be complicated and might not be cost-effective for the average family business owner.
Over the past two decades, however, a number of U.S. states (such as Alaska, Delaware, and South Dakota) have adopted statutes that expressly allow you to create and fund a spendthrift trust for yourself. Self-settled asset protection trusts under the laws of a U.S. state are sometimes referred to as "domestic asset protection trusts" ("DAPTs"), to distinguish them from the offshore variety.
You can create a DAPT in a state whose statutes expressly allow them, even if you are not a resident of that state.
How does a DAPT work?
To create a DAPT, you execute a trust agreement with a trustee that resides in a state whose statutes expressly allow self-settled spendthrift trusts. The state that you choose will become the trust's "situs," which generally means the place where the trust is administered and, to some extent, where the trust assets are located. The trust agreement will expressly provide that the trust is governed by the law of the situs state. The trust agreement will contain asset protection language that is tailored to be consistent with the situs state's statutes.
To fund the DAPT, you transfer the assets that you want to protect to the trustee in the situs state. The trustee will hold those assets for your benefit. The trust agreement can allow the trustee to distribute income or principal to you, but it will limit your rights to unilaterally withdraw trust assets, convey your interest in the trust, or terminate the trust.
Theoretically, then, if a creditor obtains a judgment against you, the creditor cannot invade the trust to satisfy the judgment and, again theoretically, a court cannot order you to withdraw trust assets to satisfy the obligation.
Pat owns a family business and a $5 million marketable securities account (i.e., publicly-traded stocks and bonds). Pat creates a DAPT and funds it with the marketable securities. Afterward, Pat personally guarantees some family business debt (but DAPT does not).
A couple of years later, the family business goes through a period of insolvency. The business's creditors proceed against Pat's personal guaranty. The creditors are able to seize a substantial amount of Pat's income from the business, putting Pat's lifestyle at risk.
Under such circumstances, Pat's creditors cannot reach the assets in the DAPT, and thus the trustee can use trust income, and principal as needed, to support Pat's lifestyle until the family business can turn around its financial woes or liquidate. If circumstances financially wipe out Pat, the DAPT will remain intact as a safety net to support Pat, while Pat recovers and rebuilds.
Why isn't this perfect?
There are some drawbacks and unknowns about DAPTs, but you can mitigate some of them.
First, you might not want a trustee making decisions about whether or not you can receive income or principal distributions from the trust, especially if that trustee is a bank in a state you never visit. You can mitigate this concern by appointing a person closer to you (personally and/or geographically) as a co-trustee or trust advisor with sole power to make distribution decisions, and you can retain the right to remove and replace that person.
Second, you might not have sufficient non-business assets to use to fund a DAPT. If you want to use a DAPT to limit business risk, it makes most sense to fund it with assets that are not related to the business. If most of your wealth is tied up in your family business, then a DAPT may not be a good fit for you.
Third, you might have pre-existing obligations that prevent you from effectively funding a DAPT. For example, if you already have personally guaranteed debts of your business, the lender might object if you substantially reduce your personal wealth by transferring it out of your control. More important, if the act of funding the DAPT renders you insolvent or otherwise causes you to be unable to pay your current obligations, then the assets that you transferred to the DAPT could be clawed back under a claim of fraudulent transfer.
Fourth, the enforceability of DAPT protection is still being tested. The concept of a DAPT is contrary to many years of established trust law in the U.S., so we are still finding out how DAPT statutes will be construed or enforced by courts, especially federal courts and courts in states whose statutes do not recognize DAPTs. Therefore, you may not want to rely upon the protection of a DAPT if you have more reliable means of sheltering your non-business assets. Often, the best approach involves a combination of asset protection mechanisms.
Finally, you will incur fees for setting up a DAPT and annual fees for trust administration. You may find that a DAPT is not cost-effective if you cannot fund it with a meaningful amount of your assets and/or if you do not have a particularly pronounced threat of personal liability risk.
If you are a family business owner, you should consider a self-settled asset protection trust, especially one that is set up and administered in the U.S., as part of a plan to protect your non-business assets from risk related to your involvement in, or reliance on, family business operations.