July 2011 - Vandrew Law | NJ Estate Planning, Wills, Trusts, Asset Protection

Health, Education, Maintenance, and Divorce: Dangers with Trust Ascertainable Standards

IMPORTANT UPDATE: Read an important update on this post here. The Supreme Court decision in Tannen v. Tannen has now come down and it seems using "ascertainable standards" is now permissible.

One common goal many parents have when planning their estates is protecting their children's inheritances from a divorcing spouse. With the divorce rate at 50%, this is a wise concern. One way in which clients are often smarter than asset protection planners is that they realize that the statistically most likely creditor to attach their family's assets is a divorcing spouse.

The most common way to protect the assets you desire to leave your children from divorcing spouses or any other creditor is through use of a spendthrift trust. A spendthrift trust is a legal relationship that can either be created during your life or after your death in your will. Like any other trust, it has a funky way of functioning.

The assets placed into trust have two owners. The "legal" owner is the trustee of the trust. The trustee manages all assets and has full control over them. However, the trustee has a duty to use the assets for the benefit of the "beneficiaries", who are the "beneficial owners" of the trust assets.

This all sounds pretty complicated, but it can be broken down pretty simply. Think of assets that are put into trust as being held in a box where for the most part no one can get to them. While the assets are in the box, the trustee has full control over their management. However, the trustee cannot remove the assets from the box for his own personal purposes. As soon as the trustee opens the lid on the box and starts taking stuff out, that stuff goes directly to the beneficiaries. While stuff is in the box, creditors (and divorcing spouses) shouldn't be able to touch it. After stuff comes out of the box, then creditors and divorcing spouses can get it. This is more or less how the common law of trusts has functioned for hundreds of years.

As you can see, this is a pretty good setup. You can leave your children their inheritances in trust and when they need money for legitimate purposes, the trustee opens up the box and gives them what they need. When a spouse files for divorce on the other hand, the box stays shut and the assets stay out of reach. This is of course an oversimplification to some degree, but it is a good description for purposes of this post.

Traditionally, most trust documents stated that the trustee should "open up the box" to make distributions for the "health, education, maintenance, and support" of a beneficiary. This was called an "ascertainable standard". Over time, this has almost become the formulaic trust language, and is in almost every trust I see.

Over the past decade, two documents have come about which have drastically altered the traditional description of trusts above: the Restatement (Third) of Trusts and the Uniform Trust Code. One of the major changes proposed by both is the creation of a property right held by the beneficiaries of a trust, even when the trustee has discretion over trust assets. The problem with this is that once a beneficiary has a property right in the trust assets, those assets are reachable by a spouse in divorce.

Luckily in New Jersey, our legislature has not adopted the Uniform Trust Code so its provisions are not a problem at the current time. Nor at the current time have our courts adopted the approach of the Restatement (Third) of Trusts. However, due to a recent case, I believe there are still precautions to take.

In Tannen v. Tannen, 416 N.J. Super. 248 (2010), the court specifically declined to adopt the Restatement (Third) approach in a divorce case. However, the court indicated that the New Jersey Supreme Court should consider reviewing the case and adopting Restatement (Third) approach. After reading this case, until the New Jersey Supreme Court finally does rule on the issue, I am operating under the assumption that the Restatement (Third) approach could become a reality here.

That leaves the obvious question: how do we prepare to mitigate the Restatement (Third)? I believe the best we can do is to revisit the "ascertainable standard" form language mentioned earlier. Under the Restatement (Third) approach, the beneficiaries clearly have a property right in trust property, at the very least to the extent they are entitled to distribution under the standard of distribution outlined in the trust. For that reason, I have for the most part dropped that "normal" ascertainable standard from my trust language and instead allowed the trustee to make distributions "in his sole and absolute discretion, for any purpose or no purpose". By making distributions discretionary to such a strong degree, I hope to make the best argument possible that the beneficiaries have little or no enforceable right to distribution, thereby limiting exposure to divorcing spouses to the maximum extent possible under the law.

The language does sound scary in that it gives the trustee so much discretion, but I believe this can be mitigated by choosing a reputable trustee. Also, despite the amount of discretion, the trustee still has a "fiduciary duty" to the beneficiaries which means he can be removed from his post by a court if he goes rogue and stops acting in their best interests. Despite the language, most case law generally holds that there is no such thing as a truly unreviewable standard of discretion for a trustee.

Trusts can be a little tricky, but they are a very powerful tool. If you are interested in learning more about using trusts to protect your children's inheritances, contact me for an appointment today.

TAX ADVICE DISCLAIMER: Any tax advice contained in this communication (including attachments) was not intended or written to be used, and it cannot be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

NOT LEGAL ADVICE. Everything posted here is for educational purposes only, and is not to be construed as legal advice. Do not take any action, postpone any action, or decline to take any proposed action based on this information without first engaging the representation of me or another qualified attorney. Nothing posted on Twitter or on any website shall be construed in any way as legal advice.

DISCLAIMER: I am an attorney and a CPA, however I am neither your attorney nor your CPA, and therefore no communications between us are covered by attorney-client or accountant-client privilege unless you possess a signed document which states that I currently represent you as an attorney or a CPA. In the case that such a document exists, the existence or waiver of attorney-client privilege or accountant-client privilege shall be controlled by the signed fee agreement or engagement letter.

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Revenue Ruling 77-137: KO'd By The K-1?

Last week's post talked about the asset protection properties of LLCs and LPs. For a recap, click here. One of the key points of that post was that charging order protection is beneficial because it prevents a creditor from having direct access to assets.

All over the internet, you will see that another supposed benefit of charging order protected entities is giving a creditor a "KO from a K-1". In this post, I will discuss why I think that notion is somewhat misconstrued.

Assuming that an LLC or LP keeps its default tax classification of partnership, at the end of each year it sends each of its members a Form K-1 showing the member's distributive share of the entity's income. The member then has to claim that share of income on his personal tax return and pay tax on it. According to most of what you read on the internet, if a creditor gets a charging order against a member's interest, he gets the K-1 every year and pays the tax instead of the member. This is hyped as a powerful tool because the creditor in this situation will be required to pay tax on his share of the entity's income without ever receiving a distribution of income from the entity. In other words, the creditor is being taxed on "phantom" income. According to some, this will discourage a creditor from even pursuing a charging order.

The authority for this position comes from Revenue Ruling 77-137. In the Revenue Ruling, a partner in an LP transferred his interest without approval of the other partners. Under the law of LPs (and LLCs), when this happens the transferee gets the economic interest in the entity but doesn't get to vote or participate in management. Such a transferee is called an "assignee". Anyway, in the scenario in the Revenue Ruling, the operating agreement allowed the transferor to keep his voting and management rights even though he had transferred his economic interest. The transferor then made a separate agreement with the transferee to use these voting and management powers to vote at the direction of the transferee.

The IRS ruled that in the above scenario, the transferee had all the "dominion and control" over the LP interest, so he was the proper recipient of the K-1.

As you can see, the situation in the Revenue Ruling is very different from a typical charging order scenario. First, the Revenue Ruling didn't involve a charging order at all. Second, how many times have you seen a debtor agree to exercise his rights in favor of a creditor? The situation in the Revenue Ruling was an unusual one.

Sometimes, however, I do have clients that want to pursue sending a creditor a K-1. For those clients, I do the best I can to give the creditor the "dominion and control" referenced in the Revenue Ruling. Since there is no dispositive IRS guidance on what constitutes "dominion and control" I try to establish "dominion and control" over an LLC interest for a creditor in the LLC's operating agreement as best I can, so at least there is a good faith argument for sending the creditor a K-1. If the client is willing, generally I do this by making the entry of a charging order against a member an "event of default" for that member which reduces his rights to that of an assignee. The member then has little or no "dominion or control" over the LLC interest. Then, to give the creditor comparatively more "dominion and control" than the [former] member, I give the creditor certain voting rights for the duration of the charging order.

No one can be sure that the above procedure makes the creditor the proper recipient of the K-1, especially since the creditor never consented to the "dominion and control" given to him. It does at a minimum give the LLC a reasonable good faith argument for sending the creditor the K-1. The creditor could of course try and fight the K-1 issue out in court.

That said, I wouldn't rely on "KO"ing anyone with a K-1 as a primary asset protection tool in and of itself. I doubt that many creditors will avoid pursuing a charging order solely for fear of a K-1. It's at best an extra throw-in feature for clients who want it in a closely-held LLC. In my opinion, there are many reasons to use a closely held LLC (as outlined here), but the "KO" factor isn't one of the top ones.

If you are interested in using a specially crafted, closely held LLC as part of an estate plan, I can help. Contact me for an appointment.

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The So-Called "FLP" and "FLLC" as Asset Protection Tools: The Ehmann-ized LLC

Many of you remember that in previous posts, I have talked about asset protection from charging order protected entities (LPs and LLCs; I usually prefer LLCs over LPs in New Jersey). Below is a recap from a previous post on how charging orders offer protection:

One of the best asset protection features of LLCs is "charging order protection". This is a concept borrowed from partnership law that comes from olden times.

To give you an idea of how charging orders work, consider the following example:

1. You have lots of assets. One of your assets is a 50% ownership interest in an LLC which owns and operates a rental property.

2. You are sued in an incident unrelated to the rental property. You lose and a $1M judgment is entered against you.

3. The other party in the incident is now your creditor, and you are a debtor. The creditor starts seizing your assets to cover the $1M.

4. The other party tries to seize your 50% interest in the rental property LLC.

In most states, under the law of "charging orders", the creditor cannot take your LLC interest. The only thing the creditor is entitled to is a "charging order" against your interest. A charging order is simply a lien which tells the LLC that if it decides to distribute any money to you, to give that money to the creditor instead. The creditor cannot force the LLC to actually distribute any money, nor participate in any way in management of the LLC, nor even usually get information on the LLC's activities. In New Jersey, this concept of charging orders as the sole remedy of a creditor is codified in N.J.S.A. 42:2B-45.

This charging order concept is very beneficial to you as a debtor in the example. The key is that the creditor cannot force the LLC to make any distributions. The creditor may sit with its charging order for years, never receiving anything unless the LLC chooses to make a distribution. This usually gives you leverage to negotiate a settlement with the creditor where you pay less than the amount owed, and in return the charging order is removed and the judgment considered satisfied.

As you probably gathered above, LLCs can be good asset protection tools. However, there are methods by which a creditor can pierce one and make its assets vulnerable. Usually when these entities fail, it is either because the entity was disregarded under the alter ego doctrine, or because the entity's operating agreement was held to not be executory in bankruptcy. I will address each in turn.

An LLC will be disregarded under the alter ego doctrine when it fails to have a legitimate business purpose, and/or when its assets are co-mingled with the assets of its owners. In order to avoid application of this doctrine, the following steps should be taken:

1. Keep personal use assets out of the entity. Your home, car, artwork, jewelry, etc. do not belong in one of these entities. The presence of these items in the entity strengthens a creditor's argument that the entity is a sham and should be disregarded.

2. Create a formal business purpose within the operating agreement. If the entity is operating a business, this is simple. On the other hand, if the entity is holding investment assets such as stocks, bonds, mutual funds, or other securities, extra care should be taken in drafting the purpose clause. Typically when I draft an operating agreement for an LLC owning investment assets, the purpose clause is several pages long and lists ten to fifteen different purposes. To further bolster the business purpose of the investment entity, I usually also create a Finance Committee which issues formal reports on investment strategies to management on at least an annual basis. To show that the Finance Committee is for real, I usually include a provision that expels a member for missing a certain number of Finance Committee meetings during a year.

3. Don't shuttle money in and out of the entity. If you are constantly shuttling money in and out of the entity to pay living expenses, it bolsters the argument that the assets are for personal use and that the entity should therefore be disregarded. Keep enough money outside of the entity to pay your living expenses. Limit withdrawals of assets from the entity to be as infrequent as possible.

4. Don't call the entity a "Family" LLC or LP. I personally hate the terms FLLC and FLP. An entity with the word "Family" in it implies that the assets are for personal use.

If you have an ownership interest in an LLC or LP and you declare bankruptcy, the bankruptcy trustee generally has the legal ability to ignore the state law which mandates a charging order as the sole remedy of a creditor. The trustee can then seize the entire LLC or LP interest outright. One exception to the power of the trustee to do this comes into play if the operating agreement qualifies as an "executory contract" under the bankruptcy code. The code itself doesn't do a good job of defining when an operating agreement is an "executory contract", but in In re Ehmann, 319 B.R. 200 (D.Ariz. Bkrpt. 2005) we learned gained some guidance. Some important provisions I like to use based on Ehmann:

1. The members should owe each other a fiduciary duty of good faith and fair dealing.

2. The members should have an obligation to make additional capital contributions upon the occurrence of certain events.

3. The members should have specific duties to perform for the entity (such as contributing to the aforementioned Finance Committee).

This post is just a summary of what needs to be in an LLC operating agreement in order to protect an LLC interest from creditors. A typical standard LLC operating agreement will not contain any of these provisions, which is why it is important to make sure your operating agreement is specially drafted by an attorney familiar with these concepts. If you are interested in using an LLC as part of your estate plan, contact me and we can discuss your options.

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Domestic Asset Protection Trusts: A Primer

Over the past ten years, Domestic Asset Protection Trusts ("DAPTs") have become more and more prevalent. In this post, I will be discussing what a DAPT is, the current state of the law on DAPTs, and why I believe DAPTs are appropriate only in limited circumstances.

[Note: A Domestic Asset Protection Trust ("DAPT") is a very specific type of trust, and does not refer to all trusts used for "asset protection". Many non-DAPT trusts used for "asset protection" may be appropriate in broader circumstances than DAPTs. More on this later.]

To understand DAPTs, I have to start by explaining the traditional law of self-settled trusts. A self-settled trust is a trust where the settlor is also a beneficiary. For those uninitiated, a "settlor" (also called a "grantor") is simply a person who contributes property to a trust. That contributed property is held by the trust for a group of people designated in the trust documents as the "beneficiaries". Under common law principles dating all the way back to olden times in England, if the settlor is also a beneficiary, if the settlor loses a lawsuit, the creditor can seize the assets in the trust.

Let's put this in simple terms. Joe Smith puts $1,000,000 into a trust, naming an independent third party trustee to manage the trust. Under the terms of the trust, the trustee, in his sole and absolute discretion and with no input from Joe Smith, is permitted to distribute any amounts in the trust to Joe Smith. The trustee is also permitted to refuse to make distributions to Joe Smith. Now assume Joe Smith gets sued, loses, and a judgment is entered against him. Under the traditional law of self-settled trusts, the creditor can have access to all trust assets in order to satisfy the judgment. It doesn't matter that the assets are in the control of a trustee.

Now consider a non-self-settled trust. Assume all of the earlier facts except that the trust documents now state that the trustee may only make distributions to Kim Smith, and that Kim Smith is the one who loses the lawsuit instead of Joe. In this scenario, absent fraudulent transfer, Kim's creditor would be unable to attach trust assets, despite the fact that they're set aside for Kim. This is because the trust is not self-settled. The "settlor" is Joe, since he put his assets into the trust, but Joe isn't a beneficiary.

In an effort to attract investors, many small offshore nations started passing laws overriding thousands of years of trust law. These laws in a nutshell stated that in the first example above, the creditor could not reach any assets despite the settlor also being a beneficiary.

In the United States, several states began to fear losing investments to offshore jurisdictions. They therefore passed DAPT statutes, which mirrored the offshore statutes mentioned earlier. The main states in the DAPT game are Delaware, Alaska, and Nevada. There are over a dozen other states with DAPT statutes as well, but their statutes are generally used only by their own in-state residents. On the other hand, Delaware, Alaska, and Nevada actively attract business from residents of non-DAPT states.

The big, unanswered question with DAPTs is this: if I live in a non-DAPT state and I form a DAPT in a DAPT state, will the trust assets be protected if I am sued in a non-DAPT state? In other words, as a New Jersey resident, if I form a Delaware (or Nevada, or Alaska, etc.) DAPT and am later sued in New Jersey court, will my Delaware DAPT hold up? As of the date of my writing this, there is no definitive legal answer to this question. No court of which I am aware has definitively ruled which state's laws would apply to the collections action.

Many promoters of DAPTs claim that the DAPT state's law will apply, and that the trust will hold, by relying on Hanson v. Denckla, 357 U.S. 235 (1958). I believe this case is often relied upon in situations where it doesn't apply. Hanson had a very limited holding. In a nutshell, the court held that a state court cannot apply its laws to a trust formed in another state if: 1. the state court has no in rem jurisdiction, and 2. the state court has no in personam jurisdiction over the trustee. I will address each of those prongs in turn.

For a state court not to have in rem jurisdiction over a trust formed in another state, generally the trust must have no assets located within that state. This prong is actually pretty easy to satisfy. In my example above with a New Jersey resident forming a Delaware DAPT, the New Jersey resident could simply move all of his bank and investment accounts to Delaware, and keep all New Jersey real estate out of the DAPT. The tough part is dealing with in personam jurisdiction over the trustee.

For a state court to not have in personam jurisdiction over a trustee, the trustee must have no "minimum contacts" with that state. What exactly constitutes "minimum contacts" is extremely complex, and is a topic that could occupy an entire law school semester. However, one thing we do know is that if a company solicits business in a certain state, that company has minimum contacts there. See, e.g., McGee v. Int'l Life Ins. Co., 355 U.S. 220 (1957).

And therein lies the problem. It will be very, very difficult to find a trustee for a DAPT that doesn't have minimum contacts in non-DAPT states. Most DAPT trustees are bank and trust companies that solicit business in all 50 states. In the aforementioned NJ-DE example, it would likely be easy for a New Jersey court to assert jurisdiction over a Delaware trust company acting as a DAPT trustee. This is because the trustee likely solicits business in New Jersey. Once the New Jersey court had jurisdiction, it would likely apply New Jersey (not Delaware) law to the collections action, as in conflicts of law issues courts generally apply local law in collections. The court theoretically could then order the trustee to distribute assets to a creditor.

In addition to all of this, in bankruptcy cases DAPTs are subject to an extended 10 year statute of limitations for fraudulent transfers under 11 U.S.C. 548(e). For more on that, click here.

Delaware does attempt a solution to the jurisdiction issue. Under the Delaware DAPT statute, a trustee is automatically removed upon a finding that an out-of-state court has jurisdiction over the trustee, and a new trustee is appointed by the Delaware Court of Chancery. It's hard to say how this provision would play out when it is tested for the first time. It could lead to a battle between dueling state courts.

DAPTs have their place, but clients should be aware of the risks. There are other strategies I can recommend that don't rely on the law of an outside state, and are therefore in my opinion more likely to be effective. An example of such a strategy is a more traditional trust known as a SLAT, you will be hearing about more on this blog. If you can't wait until later to hear about it, feel free to contact me for more information.

UPDATE 6/27/12: To see how to reduce some DAPT risks, click here.

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The NJ Clayton QTIP: Asset Protection, Tax Savings, and Flexibility

Oftentimes, people are so focused on tax savings in estate planning that asset protection becomes an afterthought. In my opinion, this is a mistake as I have mentioned previously here. In this post, I will discuss a strategy that accomplishes both asset protection and tax savings: the Clayton QTIP Trust. It is also a flexible structure that allows adjustments on the fly for any changes in the estate tax regime.

Although it may be morbid to say, death is an excellent asset protection opportunity. Because a dead person ( a "decedent") is obviously no longer in need of his assets, death creates a perfect opportunity to set up a non-self-settled trust. A non-self-settled trust is a trust where the settlor isn't also a beneficiary, and such trusts generally offer the most solid asset protection. Another benefit is that non-self-settled trusts aren't subject to the same restrictions on access to assets that self-settled trusts are. We are free to create a structure so that the decedent's wife and children can access assets when they need them, while preventing those assets from being subject to a creditor or a divorcing spouse.

The most obvious way to take advantage of this opportunity would be to create a trust in the decedent's will for the benefit of his spouse and children. These sort of trusts can be set up in variety of ways. One such way is the Clayton QTIP.

In a Clayton QTIP setup, the decedent's will creates a trust where the surviving spouse has certain rights to the trust assets for her life. A trusted person is named in the will as having the right to make a QTIP election over a portion of the assets. The portion over which a QTIP election is made qualifies for the marital deduction, while the remainder makes use of the decedent's New Jersey and/or federal estate tax exclusion. No New Jersey or federal estate tax is paid at the death of the first spouse.

Without such a provision the New Jersey estate tax exclusion of the first spouse could be lost at his death. The Clayton QTIP in essence allows a married couple to have a joint New Jersey estate tax exclusion of $1.35M rather than the standard $675,000. This is important because New Jersey does not allow interspousal "portability" of estate tax exclusion amounts the way that the federal estate tax law does.

The most important feature of such a trust is the flexibility. First, the decision regarding how much of the assets should qualify for the marital deduction doesn't have to be made until after death. In practical terms, this means that your will won't necessarily need to be amended every time the estate tax laws change (which has been often recently). Second, such a trust is flexible enough to have different sets of rules regarding distributions and access for different portions of the assets. This can allow you to give your children more access to certain portions of your assets should you so desire.

The options are almost limitless. We can accommodate almost any of your personal preferences in designing such a trust. Contact me for more details.

Blog of the Law Offices of Jeff Vandrew Jr, Attorney-CPA

Health, Education, Maintenance, and Divorce: Dangers with Trust Ascertainable Standards

Revenue Ruling 77-137: KO'd By The K-1?

The So-Called "FLP" and "FLLC" as Asset Protection Tools: The Ehmann-ized LLC

Domestic Asset Protection Trusts: A Primer

The NJ Clayton QTIP: Asset Protection, Tax Savings, and Flexibility