It has become exceedingly difficult for business people and professionals to conduct their affairs without exposure to the hazards of litigation and creditors arising both inside and outside their businesses. There are methods by which professionals and others with significant amounts of assets at risk may legitimately protect their personal net worth. An important new private letter ruling from the IRS highlights the International Of fshore Estate Planning Trust, perhaps the most flexible of these methods.

Litigation Proliferation

Professsionals and their insurers and other high-net-worth individuals appear to be deep pockects of last resort, readily available to compensate individuals, entities, or public bodies for any loss, real or imagined. In addition to tort liability arising out of professional practice, other liabilities arise out of the business actitivies or personal affairs of the professional or high-net-worth individual. To finance daily operations, professionals and individuals borrow substantial sums from the banks and other creditors, loans which the individual members of a firm may be required to guarantee. Individuals also face claims by creditors that arise in the ordinary course of their personal lives or perhaps out of infortunate investments made in happier times with borrowed funds. Some claims may arise merely from "status." Most notorious of these are environmental claims whereby bare titles owners or lesses of real property may be liable to state and Federal agencies for unlimited costs of alleged pollution clean ups.

It is beyond the ability of any individual singlehandedly to divert the current stream of litigation. However, those who are aware of the problem can minimize exposure to attack by the manner in which assets are held.

Investments in Exempt Assets; Gifts and Fraudulent Conveyances

Individuals with litigation risk will want to invest to the greatest extent possible in assets which, under applicable state and Federal laws, are exempt from the claims of creditors. Qualified retirement plans governed by ERISA are to a large extent protected in bankruptcy proceedings. (Some plans established by closely held corporations may not be governed by ERISA and thus may not be protected.) Qualified plans include pension plans, profit sharing plans, 401(k) plans, and Keogh plans. Although not governed by ERISA, IRAs in some states are exempt by statute. In some states, a principal residence, no matter how valuable, is completely exempt from creditors. Certain states exempt annunities and life insurance policies from creditors. Again, each high- net-worth individual should consult with experienced legal counsel to obtain a list of those assets exempt under law from attack by creditors and protected in bankruptcy.

The experienced estate planner is aware most high-net-worth individuals want to give their spouses and children a sense of security by making gifts to them, but the planner also knows a transfer of assets to loved ones, whether outright or in trust, carries with it two major risks. First, those who give vast sums of money to a spouse and children may find themselves without assets, without a spouse, and with unsympathetic children. Second, if a transfer is a fraudulent conveyance, it can be reached by the individual's creditors.

Transfers made when the transferror is involvent are obviously fraudulent conveyances. It is less obvious, but nonetheless the law, that transfers for the purpose of avoiding foreseeable creditors or hindering and delaying creditors in general may be equaly fraudulent. Professionals who assist or counsel such fraudulent conveyances may be in the eyes of an aggreived creditor joint tortfeasors. In certain circumstances, where the aggrieved creditor is a governmental entity or an agency of a government, the fraudulent conveyance may be criminal. In some juridsictions, any fraudulent conveyance may carry a criminal sanction. In all jurisdicitons, a professional who assists or counsels a fraudulent conveyance may run the risk of losing his or her license.

Individuals cannot effectively enhance their own families' security by making fraudulent conveyance, but they can do so by making generous gifts to a trust. As we shall see, there is even a trust to which gifts can be made that enhance the invividual's own security.

the Multi-Generation Trust (MGT) is the conceptional bedrock of all gifts into trusts. Typiclly, the individual is the grantor and an independent (not necessarily an institutional) trustee is chosen. The beneficiaries of the trust are the spouse and children of the grantor. The grantor makes a gift into the trust of an amount utilizing both is or her own unified credit equivalent of $600,000 and that of her or her spouse to the extent available. The trust has so-called "Crummy" provisions so that each year additional tax-free gifts can be made to the trust equal to the total of the available annual per donee exclusions. For example, if a married person has three children, the total annual per donee Crummy exclusions would be $60,000 ($10,000 for each child for both spouses). The trust provides that the trustee, in the trustee's sole discretion, not according to an ascertainable standard, can either accumulate funds or sprinkle income and/or principal to the beneficiaries.

By using the individual's unified credit and that of the spouse, as well as the available present interest exclusions, the MGT can become very substantial within a short period of time. For example, assuming an initial contribution of $1,200,000, annual contributions of $60,000, and a growth rate of six percent per annum, at the end of ten years the trust will be worth approximately $3,000,000. If the number of Crummey beneficiaries is greater or if the trust's assets grow at a faster rate, the trust will obviously be larger.

If the MGT is administered by a non-adverse trustee who accumulates and distributes the income and corpus for the benefit of the grantor's spouse, the MGT is a "grantor" trust under IRC Sec. 677. If the MGT is a grantor trust, all income, dedcutions and credits of the trust are taxable to the grantor, not to the trust or its beneficiaries. Even if IRC Sec. 677 is not applicable, a planner may intentionally cause the MGT to be a grantor trust by, for example, reserving the "power to reacquire the trust corpus by substituting other property of an equilavent value" (IRC Sec. 675).

Imaginative planners use the grantor trust rules to create substantial tax benefits for their clients. For example, if the MGT is worth $3,000,000 with an 8% taxable yield, it generates $240,000 of taxable income on which a grantor in the 33% income tax bracket will have to pay $80,000 in income taxes. Under current law, payment of the trust's taxes by the grantor is not deemed a taxable gift to the trust and thus that payment is, in effect, a gift tax free transfer to the trust.

Another advantage of grantor trust status is that transactions between the trust and the grantor do not have income tax consequences. Thus, transfers of depreciated property or transfers of negative basis property do not trigger income tax recapture. Moreover, if the grantor transfers to the trust property or partnership interests which are generating operating losses, he or she will continue to enjoy such losses on his or her personal income tax return even though the economic appreciation of the property has been tucked into the MGT.

The MGT should include a spendthrift clause so that it will be insulated from the creditors of the beneficiaries until the trust is terminated. With proper planning, that may not happen until expiration of the period permitted under the rule against perpetuities.

Flexibility is built into the MGT by giving beneficiaries or the independent trustees powers of appointment. For example, the invvididual's spouse may have the power to appoint all or part of the trust during his or her life or upon his or her death. As long as the power of appointment is not so broad as to be a general power of appointment, the trust will continue to be protected from the spouse's creditors. Retaining substantial control over the trustees gives additional flexiblity. The grantor may retain the right to appoint successor trustees, and beneficiaries may be able to remove trustees and appoint successor trustees.

After establishing an MGT, the individual may be concerned about what will happen if her or she survives the spouse. Having the spouse establish a substantial spendthrift trust for the individual's benefit is one solution. Another solution is to give the spouse a power of appointment over the trust and making that power broad enough to include the possibility of creating a trust for the benefit of the settlor himself. Care must be taken not to create reciprocal trusts and not to have a prearranged plan so a creditor (or the IRS) could argue that the individual retained a beneficial interest in the trust. If that argument prevails, the individual's creditors can reach the assets and anything they left behind will be in the individual's estate at death.

Being a Beneficiary of Your Own Trust

In many cases, the true desire of the individual is not to make a transfer into a trust for the benefit of a spouse or children, but rather to make a transfer into a trust that he or she controls and of which he or she is a beneficiary. Furthermore, he or she wants assurance the trust is protected from creditors and the assets are excluded from his or her estate at death. Until recently, such a desire would have been unrealistic, to say the least.

The IRC and its regulations do not state that a transfer into a trust, similar to the multi-generational trust, is includable in the estate of the grantor merely because the grantor is also a discretionary beneficiary of the trust. A transfer to such as trust is not a transfer with a retained life estate, a transfer taking effect at death, or a revocable transfer. However, such a trust is included in the estate of the grantor if creditos can reach the trust during his or her lifetime.

In no jurisdiction in the U.S. may a grantor rely on being a protected beneficiary of a self-settled spendthrift trust. In every jurisdiction there is a substantial possibility a court will order the trustee to exercise the trustee's powers for the benefit of a creditor to the same extent that the trustee could exercise his powers for the benefit of the settlor. Therefore a grantor cannot establish a spendthrift trust of which he or she is a beneficiary with any sense of confidence such trust is protected from his or her creditors and exclused from her or her estate for Federal estate tax purposes.

The International Offshore Estate Planning Trust

The solution is to create a trust governed by the law of a juridiction that has different rules of law. The international offshore estate planning trust (IOEPT) is just such a trust.

The IOEPT is a trust created under the laws of certain English speaking common law jurisditions located outside the U.S. such as the Bahamas, Cayman Islands, and Bermuda. These jurisdictions uniformly impose no income, gift, or estate taxes on the IOEPT and its beneficiaries. In many ways the IOEPT is similar to the multi- generation trust and like the MGT uses the unified credits of the settlor and his or her spouse, as well as thier per donee Crummey exclusions, to fund and build the trust into a very substantial asset. Like the MGT, the IOEPT is a totally discretionary trust. The trustee may accumulate or may distribute income and principal to any of the named beneficiaries. Like the typical MGT, the IOEPT offers absolutely no U.S. income tax advantages to the settlor during his or her lifetime. But unlike the MGT, the IOEPT includes the settlor among its beneficiaries.

Typically, the IOEPT grants broad limited powers of appointment to one or more of the beneficiaries (but never the settlor). Although an IOEPT usually contains secrecy and non-disclosure provisions, thus assuring the settlor of substantial privacy, corporate fiduciaries commonly request U.S. settlors to waive such provisions when the inquiry emnates from the U.S. government or one of its agencies. The IOEPT will also contain anti-duress clauses that enable the trustee to ignore requests or instructions when made under coercion, such as pursuant an order by a court that does not have jurisdiction over the trustee.

The typical trustee of an IOEPT is a bank incorporated as a trus company in the foreign jurisdiction. Although the corporate trustee may be part of a bank holding group which does business throughout the world, including the U.S., the trustee itself is careful to have no presence in the U.S. and not to conduct any business on its own behalf or on behalf of the IOEPT within the U.S. The trustee may hold and invest the trust corpus directly. In the alternative, the assets may be held by the trust in a corporation organized in a tax haven country (e.g. Cayman Islands), the stock of which is wholly owned by the trust or held by a limited partnership, the limited partnership interest of which are in turn held by the trust. Maximum protection from creditors and changing local laws or governments is achieved by locating the assets of the trust in a jurisdiction different from the domicile of the trustee and by providing in the trust a mechanism to change trustees, jurisdictions or applicable law in the event of an emergency.

In addition to the trustee, the IOEPT has a "protector" who is a person or corporation but who is not a trustee or beneficiary. The protector may exercise certain powers alone, and the trustee may exercise certain powers only with the consent of the protector. Typical of these powers are those to change trustees, change jurisdictions, and add or subtract beneficiaries. The role of the protector is unique to foreign trusts. No one plays such a role under U.S. trust law.

The laws of all the various offshore jurisdictions used for IOEPT purposes, to one degree or another, provide that the settlor's creditors have no right to reach a trust even though the settlor is a beneficiary. This, of course, presupposes the transfer into the trust was not a fraudulent conveyance. In some jurisdictions, however, the fradulent conveyance law is more favorable to the debtor than U.S. law. In certain jurisdictions, statutes have been enacted precluding future unknown creditors of the settlor from bringing a fradulent conveyance attack and, in addition, statutes have been enacted requiring creditors of the settlor to bring actions within a relatively short period following the actual transfer of property into the trust.

A Favorable Opinion

The prudent U.S. attorney will not allow a client to establish an IOEPT without first obtaining a favorable opinion from experienced local legal counsel in the jurisdiction in which the trust is organized. The opinion of local counsel will generally cover such topics as the validity and enforceability of the trust, the inability of present and future creditors of the settlor to reach trust assets (assuming no fraudulent conveyance), the absence of local taxation, and whether legal issues such as those pertaining to the bona fides of transfers to the trust will be governed by U.S. or local law.

Under IRC Sec. 679, the IOEPT described above is a grantor trust. As may be true for the MGT, grantor trust status may be deemed a substantial advantage and may faclitate the growth of the IOEPT. However, even though it is a grantor trust, a foreign trust may not be a shareholder of an S corporation and, accordingly, a settlor may not transfer S stock to his or her IOEPT. To permit transfers of S stock, many practitioners, by adding U.S. trustees and other features, have sought to draft IOEPTs that are not deemed "foreign trusts" under IRC Sec. 7701(a)(31). Avoiding "foreign trust" status for an IOEPT is akin to navigating a deep keeled boat in shoal waters. It is dangerous, there are no clearly established criteria, and the Service refuses to rule on the issue.

IOEPTs are subject to certain specific reporting requirements and excise tax provisions. Under IRC Sec. 6048, an informational return (Form 3520) must be filed upon the creation of an IOEPT and upon each transfer of assets into the trust. If appreciated property is transferred and the excise tax discussed below applies, a Form 926 must be filed. Because there are U.S. beneficiaries, an information return (Form 3520A) must be filed annually. Further, even though it is a grantor trust, the IOEPT must file each year a nonresident individual Federal income tax return (Form 1040NR) adapted for use by a trust.

In addition to information returns, IRC Sec. 1491 imposes a 35% excise tax on contributions of appreciated property to an IOEPT. The taxpayer, however, may elect under IRC Sec. 1057 of the Code to treat the transfer to the IOEPT as a taxable sale (IRC Sec. 1491 clearly does not apply to transfers of cash). Fortunately, under current IRS rulings, the excise tax is not applicable to foreign trusts governed by IRC Sec 679 until the death of the grantor when the trust ceases to be a grantor trust. Of course, if the appreciated assets are sold during the lifetime of the grantor, the income generated by such sale is then taxed to the grantor, and the excise tax may cease to be applicable. If, however, the appreciated assets are held until death, an income tax or excise tax will will be payable upon the death of the settlor.

New Private Letter Ruling

Attorneys working in the IOEPT field have assured their clients that the IOEPT is a legitimate mechanism to protect assets and accomplish estate planning objectives. They have further assured them that even though the settlor is a discretionary beneficiary, the assets will not be included in the estate. However, there is no case law that holds an IOEPT is excluded from the estate of the settlor. Furthermore, there are no regulations or revenue rulings to that effect. However, on August 20, 1992, the first private letter ruling supporting the estate tax exclusion of the IOEPT was finally issued.

Under the facts of the private letter ruling (PLR 93-32006), the two settlos of an IOEPT caused their business to be owned by a U.S. domestic limited partnership. The general partner of the limited partnership was a U.S. domestic corporation wholly owned by the settlors. The settlors proposed to transfer into the IOEPT the entire limited partnership interest, representing 90% of the operation business value into the IOEPT. The IRS held the transfer would be a taxable gift and, in addition, would be excluded from the estate of each settlor upon the settlor's death even though the trustee of the trust had the discretionary power to distribute all or none of the income and principal of the trust to either or both settlors as well as to any of their issue. Under the subject IOEPT, the trustee had the power, with the consent of the protector, an unrelated U.S. person, to add or delete beneficiaries. In addition, the mother of the settlors was both a beneficiary and the holder of a broad limited power of appointment. Thus over time, if circumstances were to change, the terms of the IOEPT could be varied by the mother's exercise of her power to consider changed circumstances.

Under the facts of PLR 93-32006, if the settlors' business grows to be worth $10,000,000 and then is sold, the partnership upon disposing of the underlying business can distribute the $10,000,000 to the IOEPT. The settlors would then be beneficiaries of aettlors $10,000,000 trust which would be beyond the reach of their creditors and no portion of which would be included in the estate of either settlor upon death.

Advice to the Leery

The individual and his or her advisors should consider the IOEPT as a means of removing assets from exposure. Because the requirements for establishing an IOEPT are exacting, it must be carefully done using the counsel of a knowledgeable attorney.