Copyright (c) 1996 University of Virginia School of Law

Virginia Tax Review

Winter, 1996

This good article on asset protection (particularly the taxation of transfers to asset protection trusts) has been heavily edited to facilitate loading. The full text can be found at 15 Va. Tax Rev. 399

ARTICLE: TAXING OFFSHORE ASSET PROTECTION TRUSTS: ICING ON THE CAKE?

By Elena Marty-Nelson

SUMMARY:

... Most offshore asset protection trusts ("OAPTs") are created by U.S.

persons for reasons that have little to do with possible tax consequences. ...

From the standpoint of current income tax treatment, a would-be grantor is no

better off with an OAPT than with a domestic asset protection trust. ... For

purposes of this article, we will assume that the asset protection trust grantor

must either pay a gift tax when he first deposits assets in the trust, or

include the trust assets in his gross estate for estate tax purposes, but not

both. ... Thus, an asset protection trust settlor could structure the trust in

such a way as to avoid gift tax on the initial transfer and instead include the

transferred assets in his gross estate for estate tax purposes. ... In the end,

neither the allure of intentional grantor trust treatment nor the benefits of

gift tax treatment on the initial transfer of assets would be available for

short-term asset protection trusts. ... To the extent that the law in this area

turns on local creditor access laws, a settlor of a self-settled discretionary

OAPT can, without sacrificing any of his objectives under the trust, basically

dictate whether a transfer faces gift tax or estate tax treatment. ...

TEXT:

[*399] [*400] I. INTRODUCTION

Most offshore asset protection trusts ("OAPTs") n1 are created by U.S.

persons n2 for reasons that have little to do with possible [*401] tax

consequences. The appeal of the foreign jurisdiction is, in most

circumstances, the protection from potential creditors afforded by an OAPT, which is generally greater than that found in its domestic counterpart. n3 Indeed, with regard to the tax aspects surrounding such offshore trusts, many argue that they are "tax neutral." n4 In other words, no tax advantage or disadvantage is derived by choosing an offshore situs for the trust.

This article inventories the federal tax dimensions of OAPTs, as compared to domestic asset protection trusts. Unlike most legal literature that has addressed this issue, n5 this article concludes that, for the time being, federal tax laws favor OAPTs on two counts. n6 First, an OAPT may, more easily than a domestic trust, entitle the taxpayer to special transfer tax [*402] benefits under a popular tax-planning tool known as an "intentional grantor trust." n7 Second, an OAPT may provide the settlor with more room to maneuver when it comes to reckoning the transfer tax consequences (i.e., gift tax versus estate tax treatment) on the initial transfer of assets to the trust. n8

Both tax benefits are conditioned on the taxpayer successfully shielding assets from his gross estate. n9 As developed below, the question of whether assets are excludable depends, in turn, on whether the transferor's creditors can access the ostensibly transferred assets. In short, if creditors can raid trust assets, the assets are deemed includable in the transferor's gross estate, ruling out any estate tax avoidance. Domestic asset protection trusts are fairly vulnerable to creditors. Thus, they often fail to qualify for the tax benefits described here. OAPTs, by contrast, are framed in offshore jurisdictions that have purposely enacted virtually impregnable barriers against creditor access. To the extent that tax consequences are tied to creditor access, the OAPT enjoys a decisive edge over its domestic counterpart. This article analyzes whether the

apparent tax advantage is warranted in light of a number of legislative policy considerations.

The decision to establish a trust offshore will, to be sure, rarely turn on

tax consequences alone. n10 Nevertheless, as the [*403] title of this

article suggests, the transfer tax benefits of an OAPT can yield a sizable

windfall for the grantor. The anomaly of an apparent tax preference for OAPTs is a central issue of this article. The first objective of this article is to explain how OAPTs are taxed. This goal is accomplished by examining separately the income and transfer tax treatment of OAPTs, including self-settled OAPTs, as well as by demonstrating that, conventional wisdom aside, there may be tax advantages to an offshore situs. This fairly straightforward claim about the tax treatment for OAPTs serves, however, to expose a deeper tax dilemma worthy of

critique. Namely, the dilemma is the degree to which the application by the courts and the Internal Revenue Service ("the Service") of the transfer tax system to asset protection trusts rests on shaky legal grounds. n11 With this theme in mind, a few words are due on related matters that lie beyond the scope of this article. Discussion of OAPTs is confined to their legitimate uses. Specifically, this article does not encompass offshore trusts used to evade United States income taxes illegally. n12 Second, while both tax advantages [*404] stem from a want of symmetry between the federal income tax and the federal transfer tax (estate and gift tax) systems, this article does not undertake to account for that anomaly. n13 A wealth of articles has struggled with the tension between these two systems and the impact this exerts on tax planning. n14 For that matter, there are several articles which challenge the goals, methods, and structure of the federal transfer tax system. n15 More modestly, this article is confined to the tax and the tax policy stakes raisedby how the income and transfer tax rules bear on OAPTs.

Before turning to specific tax issues, a general description of OAPTs is in order. Basically, OAPTs are trusts n16 framed under the laws of certain offshore jurisdictions in order to shield the assets transferred to the trust from future creditors. n17 Although OAPTs take various forms, they generally have common features. For example, the settlor of the OAPT is typically a business person or professional, such as a doctor, n18 lawyer, n19 or [*405] accountant n20 who perceives himself or herself vulnerable to runaway litigation. n21 The trust is established under laws of a foreign jurisdiction with trust legislation encouraging use of OAPTs. n22 Once created, the trust is irrevocable. n23 The trust term may be relatively short, such as 10 years, with the settlor retaining

a reversionary interest. Alternatively, the trust duration may be the maximum allowed in the offshore jurisdiction, such as 100 years, or tied to the lives of the settlor n24 or one or more of the beneficiaries. n25 The class of beneficiaries of the trust includes members of the settlor's family, such as the spouse and children, and may include the settlor. n26 A foreign trust company or financial institution may serve as the trustee. n27 Ordinarily, the trust vests the trustee with absolute discretion over distribution of trust income or principal among the designated beneficiaries. n28 The settlor, however, often provides the foreign trustee with a non-binding "letter of wishes" describing the settlor's preferences regarding distributions of trust property. n29 Moreover, the settlor typically reserves some authority over the trust either through participation in a "committee of advisors," n30 or as a "protector" of the trust with authority to replace the trustee. n31

A grasp of OAPT tax treatment starts with a working knowledge of both the federal income tax and federal transfer [*406] tax rules applicable to such trusts. Accordingly, Part II of this article examines the income tax treatment of asset protection trusts in general. Part III then outlines the transfer tax benefits available to OAPTs that lie beyond the reach of domestic asset protection trusts. Part IV discusses the methodology (or lack thereof) relied upon in reckoning transfer tax rules to OAPTs. Part V poses policy concerns raised by the tax options available for OAPTs relating both to the federal taxation system and fairness to creditors. Part VI concludes that the tax advantages of OAPTs over domestic trusts, although minor, are insupportable in light of broader policy considerations.

II. INCOME TAX TREATMENT OF ASSET PROTECTION TRUSTS IN GENERAL

The income tax benefits of trust ownership have in recent years been

significantly curtailed. At one time, trusts were favored vehicles for shifting income from a high bracket taxpayer to a lower bracket taxpayer without transferring the underlying assets directly to the donee. The name of the game was "tax-bracket shopping," that is, to have the income from the trust assets taxed not at the transferor's tax bracket but rather at a lower income tax bracket governing either the trust itself or its beneficiaries, who were often the taxpayer's children. n32

Of late, legislation has effectively eliminated income tax savings derived from shifting income to a trust. n33 Congress challenged income-shifting on two fronts. n34 First, Congress curtailed "tax-bracket shopping" both for income accumulated [*407] in the trust and income distributed to the beneficiaries. n35 For accumulated income, Congress squeezed the tax brackets for trusts so that almost all trust income is to be taxed at the highest marginal rate. n36 The Omnibus Budget Reconciliation Act of 1993 n37 provided that the highest individual marginal tax rate of 39.6% would govern trust income over $ 7,500.

n38 Accordingly, income tax savings occasioned by income-shifting to the trust in the hopes of earning the tax rate for trust accumulation of income became nominal. n39 Similarly, the "kiddie tax" provisions of the 1986 Tax Reform Act ("TRA 1986"), n40 which tax unearned income over $ 1000 of children under 14 at the parent's highest marginal rate, n41 curtailed the use of trusts to obtain a lower rate on distributions to the trust beneficiaries. n42

Second, the grantor trust rules, originally enacted as part of the Internal Revenue Code of 1954 ("1954 Code") to prevent taxpayers from shifting income to lower tax bracket taxpayers without actually relinquishing control of the property, were greatly expanded. n43 Congress had reasoned that the trust vehicle should only be respected for income tax purposes when the grantor had actually parted with dominion and control of the property. n44 Through TRA 1986, Congress vastly increased the number of cases where a grantor of a trust is treated as the owner of the trust assets, thereby thwarting income-shifting. n45

[*408] A. Grantor Trust Status as a Function of "Retained Control"

Generally, a grantor is deemed the owner of trust assets under the grantor trust rules set forth in sections 671 through 679 of the Internal Revenue Code ("the Code"). n46 Section 671 of the Code is the operative provision, n47 providing that when a trust is deemed a grantor trust, the trust is ignored for tax purposes as a separate tax entity and all items of income, deduction, and credits are includable in the grantor's income tax return. n48 Income shifting is not possible because trust income is included in the grantor's tax return. ....

VI. CONCLUSION

While the tax advantages of OAPTs over domestic trusts are, on the whole, fairly small, they nonetheless appear to heighten the already tempting impulse to set up asset protection trusts overseas....