July 1998 Hot Topics

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Copyright 1998 Robert L. Sommers, all rights reserved.

Off-Shore Asset Protection Trusts - Part 1

Note: Part One of this Two-Part Series introduces the concept of asset protection, whether or not it works, and the U.S. tax filing requirements imposed on the grantors, trustees and beneficiaries.  There is also a discussion of recent tax cases involving those attempting to hide their assets from the IRS.
 
Part Two, October's Hot Topics, will analyze the fraudulent transfer laws, potential criminal liability relating to fraudulent transfers to evade creditors or the IRS and recent  non-tax cases in which these trusts failed to protect those forming them against their creditors.

Introduction

The highly-hyped "off-shore asset protection trust" is the latest strategy for those attempting to stiff their creditors (real or imagined) or the IRS.  Asset protection means arranging one's business and financial affairs to minimize exposure to creditors.  Corporations, limited partnerships and limited liability companies are state-sanctioned asset protection vehicles, since they limit an investor's potential liability to the amount invested, thus shielding the investor's other assets (investments, bank accounts and residences) from the claims of creditors.

Although asset protection is a standard part of business and estate planning and is encouraged by state law, the off-shore asset protection trust is a different animal.  In contrast to statutory asset protection, which limits one's liability, off-shore asset protection involves transferring assets (or legal title to assets) to a foreign jurisdiction, thereby, in theory, placing those assets beyond the reach of  U.S. court judgments.  Generally, these foreign jurisdiction have enacted special legislation that protects debtors against foreign creditors.  These laws often run contrary to long-settled U.S. and English legal concepts. Whereas foreign jurisdictions, such as Switzerland, have long-served as a haven for those persecuted in their home countries for religious or political beliefs, the modern asset protection countries are providing protection for those escaping their home country's legal and tax systems.


Asset Protection is Risky Business

Asset protection is a growth industry.  In fact, the prestigious RIA Group publishes a Journal of Asset Protection, which contains such uncritical articles as "An Impassioned Argument for Offshore Advocacy as an Ethical Duty."   Ironically, the same journal published a four-part article  entitled "Minimizing Attorney Liability in Asset Protection Representation" (which should be required reading for the asset protection advocates. Note: An important part of the liability attorneys must minimize is criminal.).  However, when the Journal actually reports on cases involving asset protection, the debtors are consistently on the losing side.   In fact, none of the articles and cases cited in the several journals I previewed ever upheld a foreign asset-protection scheme when challenged by a debtor in a U.S. court.

Those claiming legitimate asset-protection benefits for these vehicles admit there are no U.S. tax advantages.  To the contrary, the tax reporting requirements are complex and the potential penalties for non-compliance are huge.   Furthermore, the IRS has little trouble compelling taxpayers to disclose their assets.

In the typical case, a U.S. citizen (usually a doctor, attorney, accountant, stock broker, business owner or someone with a large liability exposure) will transfer assets to a trust established in a foreign country to avoid paying on a U.S. court judgment.  To attract these investors, the foreign country will have enacted "asset protection" legislation, severely restricting the rights of creditors to recover against the investor -- in violation of settled trust law principles.  In essence, the investor supposedly has placed his assets beyond the reach of the U.S. legal system to recover any judgments rendered against him.  By using the laws of the asset protection jurisdiction, the theory goes, the investor has become judgment-proof (i.e. his assets have been placed beyond the reach of his creditors).


Does Off-Shore Asset Protection Actually Work?

But do these trusts actually work to prevent creditors from reaching your assets? Based on the court cases thus far, the short answer is -- NO.  Creating an off-shore asset protection trust does not offer much legal protection against determined creditors.  Hiding one's assets overseas may have the practical effect of discouraging creditors from proceeding with a lawsuit in the first place (or settling for less) because of the added expense and risk that they will not be able to collect on a judgment. This deterrence factor is probably the main advantage of using an off-shore asset protection trust, although a well-designed domestic asset protection strategy will, in reality, provide the same benefits and should costs thousands less to create and maintain.  In fact, a properly structured limited liability company formed under state law will provide as much, if not more, protection as the most complex and expensive off-shore arrangement.

The major drawback to off-shore asset protection planning is the mind-set of the typical client who wants to transfer assets outside the U.S.  Usually, they are motivated by illegal or improper purposes, such as placing their assets beyond the reach of creditors after a lawsuit has been filed or threatened, or a desire to cheat on their taxes (a criminal felony). 

Another problem with asset protection is the enormous power of U.S. bankruptcy laws.  For instance, if a debtor transfers assets abroad so that his creditors cannot reach those assets to satisfy their claims, he has probably made himself insolvent.  By making himself insolvent, his creditors can force him into bankruptcy and a trustee will take charge of the debtor's estate.  The trustee can, under some circumstances, waive attorney-client privilege and obtain the confidential information provided by the attorney to the debtor.  A trustee would have little trouble obtaining tax return and tax reporting information exposing the debtor's foreign assets.  Armed with this information, the trustee is in a position to undo the asset protection scheme and reclaim the assets for the creditors.

Note:  The basic premise of off-shore asset protection -- that the laws of the foreign jurisdiction (which contradict well-settled trust law principles) will be enforced to "protect" the debtor against his creditors -- is  flawed.  To date, U.S. courts have not upheld laws of a foreign jurisdiction which oppose the public policy of the applicable state law.  Applicable state law is usually where the debtor is domiciled ( lives permanently).

Because these foreign laws are purposely designed to protect debtors by overruling settled trust law, these laws cannot withstand an attack on public policy grounds.  In other words, it is highly unlikely that a state court judge will overrule the law in his or her jurisdiction and apply the laws of a foreign country, when those foreign laws were intentionally drafted to contradict state law that would otherwise apply.

Another claim made in favor of asset protection is that the foreign country will not enforce a U.S. judgment against a U.S. settlor (debtor) who created the asset protection trust.  While this premise is not as solid as it sounds (see discussion below), the focus is misplaced.  The critical issue is whether a U.S. court having jurisdiction over the debtor (because he or she is domiciled in the state) will nullify the transfer of assets to an off-shore trust under state law principles or otherwise rule that the transfer of assets to the foreign trust was invalid or illegal in the first place.


Large Fees for Routine but Dangerous Work

While some attorneys defend this emerging area of law, often claiming that attorneys actually have an  "ethical duty" to advise clients about off-shore asset protection schemes, a survey of the fees charged indicates that asset protection trusts generally cost between $12,000 to $15,000 to create.  This is about three to five times the usual cost of a regular estate plan drafted by an expert estate planner, which do not  include annual fees of approximately $3,000 a year. (Source:   Journal of Asset Protection, November/December 1997, Exhibit 1, page 15).  Since there are asset protection form books and other materials readily available to make this work routine, it is difficult to justify the 300% to 500% mark-up as anything other than a premium for engaging in a dangerous and risky activity.

In other words, if this area of law works as its proponents claim, why are their fees so high?  Granted, the attorney may perform "due diligence" investigating the client's motives (a novel concept: the attorney and client as adversaries) to protect against a later charge that the attorney committed civil or criminal fraud or otherwise engaged in improper, illegal or unethical conduct in connection with the transfer of assets to a foreign trust. But does the cost of protecting an attorney against his client's potentially nefarious schemes really justify the high mark-up?


Tax Filings for Offshore Trusts

If you like spending lots of time filing tax forms and disclosing your financial activities to the IRS, then you'll love the new disclosure requirements for off-shore trusts. Trust grantors may have to file as much as 6 information forms, trustees and fiduciaries also have six information forms to consider, trust beneficiaries have five forms that pertain to them and three forms relate to those meeting the definition of a "responsible party." And if you fail to comply this these requirements, your are looking at hefty penalties that could wipe out your foreign account altogether. Check out Notice 97-34 for a detailed explanation of the new reporting requirements.

Be sure the person advising you about off-shore protection trusts describes in detail each of these reporting requirements and your obligations to comply with them.  Also, remember that a trustee in bankruptcy will have little trouble obtaining this information and using it to attach your off-shore asset protection trust.


Filings by Grantor

The grantor (or transferor), beneficiary and fiduciary of a foreign grantor trust must file the following forms in regards to an offshore trust asset protection plan:

1. IRS Form 1040: Schedule B, Part III

A grantor or transferor must report on this Schedule of their individual tax return for the year of transfer or creation, information regarding the creation of a foreign trust or the transfer of property to that trust, and the existence of any financial account in a foreign country in which the taxpayer has an interest or signatory authority.

2. IRS Form 3520: U.S. Informational Return – Creation of or Transfers To Certain Foreign Trusts

The following information is reported on this form: the names, addresses, and taxpayer identification numbers of the foreign trust, the fiduciary, the beneficiaries and their percentage interest, the amount of cash and value of other property transferred to the foreign trust, and the location of the foreign trust’s books and records. This form must be filed as an attachment to the grantor’s income tax return no later than the due date or the return for the taxable year of the transfer, along with a copy to the Philadelphia IRS Service by the same date. The IRS is revising Form 3520 and the new form must be used to meet the new reporting requirements.

3. IRS Form 3520-A: Annual Return of Foreign Trust with U.S. Beneficiary(s)

Under IRC Section 679, the U.S. grantor or transferor that would be subject to income tax will be responsible for failure to file or comply with the annual return requirements.

4. IRS Form 926: Return by a Transferor of Property to a Foreign Corporation, Foreign Estate or Trust, or Foreign Partnership

There should be no requirement that this form be filed with respect to foreign grantor trusts. However, this form is still required where foreign corporations are set up, directly or indirectly, by U.S. persons.

5. IRS Form 709: Gift Tax Return

There should be no need to file this form upon the transfer of assets to an offshore trust if certain powers are retained by the grantor or transferor, precluding a gift for gift tax purposes.

6. TDF 90-22.1: Report of Foreign Bank and Financial Accounts

The following U.S. persons must file this report annually: persons with a financial interest in bank securities or other financial accounts in a foreign country which is in excess of $10,000 in the aggregate, and those with signature authority in such accounts. Where a trust account is set up offshore requiring the signature of both the trustee and the trust protector to facilitate withdrawals, the trust protector may be required to file form TDF 90-22.1


Filings by Fiduciary

A trustee or fiduciary is requirement to file the following forms:

1. IRS Form 3520-A: Annual Return of Foreign Trust with U.S. Beneficiary(s)

This form is filed annually and should provide the IRS with a complete accounting of the activities of the foreign trust for the year; the identity of the limited agent designated to receive requests for information from the IRS, and any other information required by law. The trustee is required to file this form by the 15th day of the third month following the end of the taxable year of the foreign trust. Pending revision of this form by the IRS, the trustee should do the following: insert "Foreign Grantor Trust" at the top of the Form; complete the identifying information on the Form; attach the form a Foreign Grantor Trust Information Statement; execute an Authorization of U.S. Agent form before the due date for the form; execute and date the form; send to each U.S. owner the Foreign Grantor Trust Owner Statement (by the due date for filing this form with the IRS); and the Foreign Grantor Trust Beneficiary Statement to each U.S. beneficiary who received a distribution from the foreign trust during the taxable year (by the due date of filing this form with the IRS).

2. IRS Form 56: Notice Concerning Fiduciary Relationship

This form, which is a notice of fiduciary authority over a foreign trust with U.S. income, may not be a required filing.

3. IRS Form SS-4

This is the form used to obtain an Employer Identification Number from the IRS.

4. IRS Form 8288-A: Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests

This form should not be required if the foreign trust is treated as a grantor trust.

5. Informational Report Required by IRC Section 6039C(a)

Currently, there are no forms that exist for this requirement. This informational return may be required of any foreign person owning certain investments in U.S. real property interests with a value of $50,000 or more.

6. Form W-9: Request for Taxpayer Identification Number and Certification

The trustee may file this form to obtain the correct Employer Identification Number or Taxpayer Identification Number of the U.S. Agent, the U.S. beneficiaries, and the U.S. owner.


Filings by U.S. Beneficiary

The U.S. beneficiary of a foreign grantor trust should provide the following forms:

1. IRS Form 1040: Schedule B, Part III

A beneficiary must report all of its beneficial interest in a foreign trust in this Schedule of their individual tax returns.

2. IRS Form 1040 (Other Portions)

Beneficiaries are supposed to report any income they receive from foreign trusts in other portions of their individual tax returns, to the extent it is not reported by the transferors to the trust under the grantor trust rules.

3. TDF90-22.1: Report of Foreign Bank and Financial Accounts

4. Form 8288: U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests

5. IRS Form 3520: U.S. Informational Return – Creation of or transfers to Certain Foreign Trusts

Under IRC Section 6048(c), U.S. beneficiaries who have received distributions during the year are required to report the name of the foreign trust, the aggregate amount of the distribution, and other information under Notice 97-34. A beneficiary who receives a distribution from a foreign trust must receive from the foreign trust a Foreign Grantor Trust Beneficiary Statement which must be attached to the U.S. beneficiary’s or U.S. grantor’s Form 3520. This form must be filed by the due date of the beneficiary’s or grantor’s income tax return for the year of the receipt of the distribution, subject to certain transition rules.


Filings by the "Responsible Party"

1.  Reportable Events

A "responsible party" includes a grantor and a transferor to a foreign trust, and the executor of a foreign estate. A responsible party is required to report the following "reportable events" on or before the 90th day following occurrence: the creation of a foreign trust by a U.S. person, the direct or indirect transfer of money to a foreign trust, and the death of a U.S. resident or citizen, who, under the grantor trust rules, was treated as the owner of any part of a foreign trust, or whose gross estate includes a portion of the foreign trust. A responsible party who fails to report such reportable events can be assessed a penalty tax of 35% based on the gross value of the property triggering the reportable event.

2.  Reporting of Trust Activities

A U.S. person who is treated as an owner of a portion of a foreign trust under the grantor trust rules is, on an annual basis, responsible for: seeing that the trust makes an annual accounting of trust activities, identifying the designated U.S. agent, and providing any other information required by the regulations. This information must also be provided to any other U.S. person who is treated as an owner of any portion of the trust. There is a penalty of 5% of the gross value of the foreign trust deemed owned by the U.S. person under the grantor trust rules for failure to make these reports.

3.  Report of U.S. Beneficiary’s Receipt of Distribution

A beneficiary is required to file a return disclosing the name of the trust, the total yearly distribution and any other information required by the regulations for any year in which a U.S. person receives a distribution from a foreign trust.


But the IRS Can't Make You Tell It About Your Off-Shore Trust, Can It?

Not only can the IRS make you tell it about your off-shore trust, it can force you to waive any secrecy laws that could apply in the foreign jurisdiction.  In U.S. v. Spearbeck, 80 AFTR 2d Par. 97-5085 (West District of Washington, June 3, 1997), a U.S. District Court ordered the taxpayer to sign several consent directives, allowing the IRS to obtain their financial records from foreign banks and institutions.   The IRS contended, and the court agreed, that the financial records were necessary to determine the taxpayer's past and future tax liabilities as well as to identify potential assets from which to pay tax liabilities.  The taxpayer argued that such a court order violated their rights to privacy.  The court found there was no right to privacy involving financial records in domestic or foreign institutions.

The lesson:  A foreign jurisdiction's secrecy laws are of little protection against the IRS.  The taxpayers can either comply with a U.S. court's order to waive secrecy or spend months in jail for contempt of court.


Transferring Assets Off-Shore May Be Hazardous To Your Financial Health

Just how strong is the IRS's power in the area of off-shore transfers?   Just ask Salih Zamzam.  When the IRS notified Mr. Zamzam of a tax audit, he immediately transferred about $2,000,000 to a Swiss bank account, beyond the reach of the IRS, or so he thought.  Bad move.  In Zamzam v. U.S., 79 AFTR2d Par 97-115 (District Court for Western District of Virginia, February 28, 1997) the IRS made "jeopardy assessments" against the taxpayer and his medical corporation in excess of $1,000,000.

Note:  A jeopardy assessment is an immediate assessment and demand for full payment, bypassing the normal IRS audit and administrative review procedures. The IRS is permitted to make a jeopardy assessment when it believes the taxpayer is placing his assets beyond the reach of the government, by removing it from the United States, concealing it, dissipating it or transferring it to another person.

The lesson:  If you move your assets off-shore when an IRS audit is pending, expect an immediate assessment and demand for tax payment.





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