Bankruptcy Considerations for Domestic Asset Protection Trusts

April 13, 2006

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While federal bankruptcy courts have jurisdiction that stretches across the states, it is an oversimplification to state that a domestic asset protection trust could not survive in a bankruptcy proceeding. Federal bankruptcy law requires that the court honor any exemption established under state law.

Thus, in a bankruptcy proceeding, the same issue is presented--which state's laws will be applied? If the bankruptcy court finds that Alaska or Delaware law applies to the trust, because of investing in real property or forming business contacts in the state, for example, then the trust will be upheld as valid and exempt from the bankruptcy proceeding.

At this time, the outcome cannot be safely predicted. Arguments can be made that support either position. Because of the distinct advantages of these new asset protection trusts, and the significant protections offered particularly by Alaska's statute, one thing probably can be safely predicted--when a significant sum is at stake, a creditor is likely to challenge the validity of the trust on the grounds discussed above.

Warning

To date, there have been no reported cases on the validity of an Alaska or Delaware asset protection trust against a challenge mounted outside one of these states. For this reason, some planners still recommend offshore asset protection trusts rather than domestic trusts.

However, offshore trusts are more expensive to establish. Further, many individuals are hesitant about investing offshore, because of concerns (mostly unfounded) about the jurisdiction's stability, currency valuation issues, etc. Finally, offshore trusts also can be challenged, but only in very specific ways.

You should consult with an estate planning attorney before deciding whether to establish a self-settled asset protection trust, and, if such a trust is to be formed, whether to use Alaska, Delaware or an offshore jurisdiction for the trust's establishment.

If the decision is made to establish a domestic asset protection trust, consideration should be given to using the strategies of investing in real property or forming business contacts there to bolster the argument that Alaska or Delaware law should be applied to the trust.

Note that if the trustor is a resident of Alaska or Delaware, an issue can still exist as to validity of the Alaska or Delaware asset protection trust when the creditor is a resident of a different state, or the creditor's claim is based on an event that occurred in another state. An Alaska trust might, for example, be challenged by a former spouse, pursuant to a court judgment of alimony or child support from another state. Or the trust might be challenged by a creditor based on an auto accident that occurred in another state.

However, if you are a resident of Alaska or Delaware, it is probably less likely that the trust will be successfully challenged. Your residency will make it more likely that a federal court will find that Alaska or Delaware law should apply to the case. Nevertheless, because of the absence of direct rulings on the issue, this result is far from guaranteed.