For decades, high-net worth U.S. citizens and resident aliens have used offshore trusts. In fact, up until the 1960s, moving your assets offshore provided a three-pronged solution to the important issues of asset protection, investment diversification and tax minimization. Of course, there are other benefits to establishing certain forms of offshore trusts, but these are the only three that have (or had) advantages not available in the domestic trust context. In this article, we will explore how the use of offshore trusts by U.S. citizens has evolved.

Asset Protection

Traditionally, domestic asset protection trusts have not offered a great deal of true asset protection to U.S. citizens and residents. The reason for this was based on a public policy concern that one should not have the ability to avoid one's creditors by transferring assets to a trust, particularly if the trust was created for one's own benefit (known as a "self-settled" trust). However, historically, asset protection has been available through the use of self-settled offshore trusts.

However, let’s first review the four key elements in proper protection from creditors those assets transferred to a trust.

1. The assets cannot be fraudulently transferred. This means that you cannot be aware of existing or looming creditors (who have claims greater than your remaining ability to pay) when transferring assets to such a trust;

2. The trust must be established as irrevocable. This means that the settlor of the trust cannot maintain any powers associated with ownership of the trust or the trust property;

3. Distributions from the trust must be discretionary in the judgment of an independent trustee;

4. The trust instrument must include "spendthrift" provisions which provide, among other things, that creditors of the beneficiaries of the trust cannot reach the trust assets.

In the domestic context, while a trust having spendthrift provisions established for the benefit of someone other than the settlor of the trust can generally shield the trust assets from the creditors of that beneficiary, spendthrift provisions in self-settled trusts (those in which the settlor is also a beneficiary of the trust) are generally unenforceable under the laws of most states.

In recent years, the states of Alaska, Delaware, Nevada and Rhode Island enacted legislation which offers some protection to the assets placed in self-settled trusts. However, there are three negative concerns raised with the use of a domestic asset protection trust, even if it’s created in one of these favorable jurisdictions:

1. The "conflict of law" or "choice of law" issue is a key concern. While the common law generally provides that the settlor's choice of law for a trust would govern, many principles that conflict with this result have been successfully advanced in the courts. For example, today, the situs of real estate and the law where a tort occurred will generally govern where an action may be brought relating to those issues.

2. Another concern is the Full Faith and Credit Clause of the U.S. Constitution. This clause provides that a valid judgment rendered in one state must be recognized in another state. In analyzing this issue in conjunction with the issue discussed above relating to conflict of law, you can see that if, for example, a trust is established in Delaware, then the Delaware courts may claim jurisdiction over a claim made against the settlor in his or her home state and seek to enforce that judgment in the state in which the trust was established. This is, obviously, an unpleasant and unintended result.

3. The Supremacy Clause of the U.S. Constitution could create an issue if a judgment creditor petitions for the involuntary bankruptcy of a transferor. Since the Bankruptcy Act is a federal law and federal law trumps state law under the Supremacy Clause, the bankruptcy court (i.e., a federal court) may apply federal law in adjudicating the case.

Since the asset protection laws in Alaska, Delaware, Nevada and Rhode Island are still relatively new, uncertainty exists as to how these issues will be adjudicated.

Which brings us to the offshore trust, which addresses these concerns in the following ways:

Conflicts of law and choice of law issues are definitively settled in many foreign jurisdictions. Only the foreign law will apply since offshore jurisdictions are not subject to the control of U.S. courts.

There are no Full Faith and Credit Clause issues in the foreign context.

There are no Supremacy Clause issues in the foreign setting.

A host of asset protection-related issues, beyond the threshold question of the enforceability of self-settled spendthrift provisions, is definitively and favorably set forth in the laws of certain foreign jurisdictions.

With that being said, are offshore trusts the best approach for all high-net worth individuals? The answer is: Absolutely not!

You must first consider a variety of other issues, not the least of which is the profile of the individual. For example, if the individual is a high-profile person, such as a founder or CEO of a public company, he may not want the potential poor publicity resulting from such information becoming "news." There isn’t anything inherently wrong or illegal about establishing an offshore trust with asset protection features; it is simply that if anyone is under the scrutiny of the media and/or the public, the perception (which were created largely by former abusers of the laws in place at the time) may be unfavorable, or at least unflattering.

Investment Diversification

Savvy investors, particularly those who accept modern portfolio theory, seek to diversify their portfolios as a tool in order to help reduce volatility and spread risk. Due to the globalization of the major economies of the world, international markets provide investors with a significantly expanded universe of investment choices to do just that.

Diversification among international securities can help:

Reduce and spread the risk of currency fluctuations affecting investments;

Reduce the negative effect of certain political events in any one country; and

Reduce the negative effect of certain regulatory changes in one jurisdiction's securities, monetary or tax policy that may compromise the value of investments in that market.

However, many investments, such as Eurobonds and foreign mutual funds, are not directly available to most U.S. investors. For example, Eurodollar bonds avoid stringent U.S. reporting requirements because they are issued in bearer form and do not have to follow Securities and Exchange Commission regulations. The result is that they cannot be sold directly to most individual U.S. investors. To prevent U.S. investors from purchasing newly issued Eurodollar bonds, the SEC requires a time lag called a "seasoning" period in which such sales can only take place 90 days after the date the bond is first issued. Therefore, the investor misses out on what could have been the best pricing for these bonds.

Once again, enter the offshore trust. An offshore trust permits more economical and advantageous purchases of foreign securities either directly or through foreign mutual funds. The offshore trust is generally treated as a foreign person for SEC purposes, therefore avoiding the reporting requirements of purchasing foreign securities which ordinarily would occur if the purchase was made directly by a U.S. investor.

Tax Minimization

Under certain circumstances, it used to be legal for U.S. taxpayers to defer income taxes through the use of a foreign trust until the monies were repatriated. Now, because of U.S. Internal Revenue Code S679, part of the so-called "grantor trust" rules, a U.S. taxpayer establishing a foreign trust having any U.S. beneficiaries is treated as the owner of the assets in the trust for income tax purposes, making this a "tax-neutral" vehicle (i.e., there is no difference in taxation whether domestic or foreign). Therefore, even though such a trust is a foreign trust, it is considered a grantor trust for income tax purposes, and all trust income, gains and losses are passed through to the grantor; meaning, of course, that there is no longer any such thing as tax deferral or tax avoidance simply by shipping assets overseas to an offshore trust account.

Enter the offshore trust? No, not necessarily, at least for tax minimization purposes. However, there is still one tax advantage remaining for U.S. taxpayers establishing offshore trusts. After the death of the settlor, the foreign trust ceases to be subject to U.S. income taxes until the funds are distributed to a U.S. beneficiary, and, if the trust is established in certain jurisdictions, it can be created as a "perpetual" or "dynasty" trust for future generations, deferring income tax until distributed and bypassing estate tax at each such generational level.

Therefore, it can be said that while the asset protection benefits of using offshore trusts today are as strong, or even stronger, than in the past and the benefits of using offshore trusts for investment diversifications have expanded with market globalization, the tax effects of establishing an offshore trust are generally neutral as compared with establishing a domestic trust.

If you would like more information regarding asset protection, trusts, family limited partnerships or the subject of this article please call or email our office.