Hi again and welcome to the Friday Edition. I’m Phil and I’m writing this from Seat 20A on AC787 from Toronto to Los Angeles.

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Closing a asset protection trust

I received a forwarded email from a friend at the Wall Street Journal this week that raised an interesting practical question: how do you terminate an asset protection trust after the risks have passed?

The question (edited by me to hide identifying information) is this:

How can I repatriate a “declared” foreign trust (i.e., US taxes paid ever since the trust was created in 1994). The reason I created the foreign trust initially was a medical malpractice lawsuit (from a patient I never touched but whose chart had only my name on it) that cost me $450,000.

I see no further need for the foreign trust and prefer to have the assets here in the US. Is there any special procedure or declaration necessary?

The foreign bank has no objection to the transfer, it is the US banks that need “reassurance” that this is not laundered money.

Thanks for any help or direction you can provide.

I do not know anything about this person or the trust. So, dear correspondent, this is not legal advice to you at all. I just want to show you that the the final step — “When Mama’s the bank is happy, everybody’s happy” — is preceded by a number of other things that you should think about.

And I figured that writing about this out loud might be useful. There might be a few other people out there with old asset protection trusts that should be terminated.

The nine hurdles

There are nine things this person needs to consider in terminating the foreign trust:

  1. Have the risks disappeared?
  2. Does the trust document say you are a beneficiary?
  3. If the trust document says you are not a beneficiary, can you be added as a beneficiary?
  4. Once you are a beneficiary, will the trustee exercise its powers and distribute money to you?
  5. What are the trustee’s requirements for termination of the trust (and for covering its corporate butt)?
  6. What are the U.S. income tax considerations?
  7. What are the U.S. estate tax considerations?
  8. What are the U.S. tax paperwork considerations?
  9. What are the requirements of the U.S. bank where the trust distribution will land?

This is a giant game of trust law, tax law, and banking croquet. You will have to hit the ball through the hoops in the right order if you want to win the game.

Hurdle 1 – risks

An asset protection trust is no longer necessary if there are no risks. It appears that this person has retired and no longer faces medical malpractice lawsuit risks.

If you are looking to unwind an asset protection trust, look over the landscape. Are there still scary monsters out there?

Hurdle 2 – are you a beneficiary?

The trust itself has explicit rules for who may receive distributions, and when. Only beneficiaries may receive distributions. You must be a beneficiary of the trust in order to receive anything.

Here are the possibilities:

  • You are named as a beneficiary of the trust. Good news.
  • You are identifiably a member of a class of people who are beneficiaries, even though you are not named. Good news.
  • You are not a beneficiary of the trust (either by name or by membership in the class of beneficiaries), but you are not banned, either. (Look for provisions that identify “Excluded Persons” and see if you are in that group.) Semi-good news. Extra work needs to be done to make you a beneficiary, but receiving a distribution is still possible. See below.
  • You are not a beneficiary of the trust, and you are banned from becoming a beneficiary of the trust. You are SOOL. You will have to find some other way of getting the assets out of the trust.​

Read the trust and see what it says.

Hurdle 3 – if you aren’t a beneficiary but can be added . . .

Usually a trust document for a foreign trust will give the trustee — or another person called a “Protector” or “Guardian” — discretionary power to add or remove beneficiaries.

Does such a provision exist? If so, this is tentative good news. Someone can add you as a beneficiary. (This assumes, of course, that you are not an Excluded Person who can never be added as a beneficiary of the trust — by the very terms of the trust document itself.)

  • A Protector or Guardian can usually force the result and arbitrarily make you a beneficiary of the trust. This is good. People who serve in this capacity are usually friendly to you and are decisive and unafraid.
  • A trustee usually has the discretion to add you as a beneficiary. Trustees may or may not do this — they are afraid of being sued by the other beneficiaries for dereliction of (fiduciary) duty. This is tentative good news. Now you must assuage the trustee’s fear.

Let’s assume that either you are identifiably a beneficiary of the foreign trust, or are added as a beneficiary by the Protector or the trustee.

Hurdle 4 – will the trustee distribute assets to you?

You have not solved all of the problems just because you are a beneficiary of the trust. The trustee must push the proverbial button and actually take money out of the trust and give it to you.

A distribution to you from the trust is either required or optional. Asset protection trusts will never have mandatory distributions from the trust to you, because that would put the assets at risk if you are sued.

So a typical asset protection trust will give the trustee complete discretion to distribution money (or not) to any beneficiary at all.

Will the trustee exercise its discretion and distribute the money to you?

Well, this is a function of the trustee’s fear. A trustee signs on for the job of guarding the trust assets for the beneficiaries. The beneficiaries include you and everyone else who comes after you. The trustee must treat everyone fairly and not favor one beneficiary over the rest, typically.

If the trustee gives you all of the money from the trust and leaves nothing there for the other beneficiaries (probably your kids, grandchildren, spouse, etc.), the trustee will wonder whether it will get sued by the others for giving you all of the money outright so you could run to Vegas and bet it all on red.

Again, your Protector may come to the rescue. If the Protector orders the trustee to distribute all of the money to you and none to your spouse, children, grandchildren, etc., then the trustee has no risk and will say “Just following orders!” if there is a lawsuit by the other beneficiaries.

If you do not have a Protector (or your Protector is unwilling to do this) you will have to ask the trustee nicely and hope for the best.

Let’s assume that the trustee is willing to distribute money to you on its own, or is willing to distribute money to you because the Protector says so.

Hurdle 5 – the trustee is not responsible for anything

You are a beneficiary of the trust. The trustee is willing to distribute the trust assets to you outright and terminate the trust.

But the trustee is afraid. You will almost certainly be given a document to sign that fully releases the trustee from liability for its actions as trustee of your trust. This may bug you mightily.

Get over it.

Take a scan over the entire life history of the trust and see if you think something went dreadfully wrong. Usually this is in the tax compliance. Unless the trustee stole your money and screwed you mightily in the eyes of the IRS, it is not worth your time and money to fight.

Trustees are risk-averse in the extreme. That’s the whole reason that independent trustees exist — to protect the assets and be hyper-prudent. You liked this character trait before. Now it’s an impediment to action. Give up. Get your money and move on.

Check out the paperwork, delete egregious stuff (maybe not even that!), sign it, and reassure the trustee.

Now the trustee has the power and the willingness to exercise that power to distribute the money to you.

Not yet. Hang on a sec.

Hurdle 6 – U.S. income tax

Check out the U.S. income tax costs to you. My correspondent is certain that everything is OK and tax was paid all along. Great.

For the rest of you, check the income taxation of the trust’s assets while the trust existed. Was everything done right?

Quite often a foreign trust will not own assets directly. Rather, it will own a foreign corporation in which all of the assets will be stored. Did you check the U.S. income tax consequences of this?

Then double check the distribution that you will be getting when the trust terminates. Do a dry run in preparing Form 3520 and Form 3520-A. What happened? Did you uncover an “oops” that made the trust distribution into taxable income for you?

Better to know this before the money hits your account. By then it will be too late, and if the distribution is really taxable (rather than nontaxable, as you would obviously prefer), you are likely to shed a few bitter tears.

Look before you leap, etc.

Hurdle 7 – U.S. estate tax consequences

Are the trust assets out of your taxable estate right now? If you receive the trust assets as an outright distribution, will you suddenly have an estate tax problem when you die?

For estate tax reasons you might want to leave the assets in the trust.

(Note also that there are some advantages for pre-1996 foreign trusts. Foreign trust tax law was substantially changed in 1996. My correspondent’s trust was created in 1994. Are these advantages enough to keep the foreign trust?)

Hurdle 8 – the tax paperwork

The IRS has a metric ton of paperwork requirements for foreign trusts. The two obvious ones are Form 3520 and Form 3520-A. There may be others.

The default penalty for most of the paperwork requirements is “$10,000 and maybe higher” if you make a mistake or do not file the paperwork on time.

Again, this is a “look before you leap” thing. You might want to clean things up. If you do, know your strategy before you actually terminate the trust.

This step involves a backward-looking “is everything OK?” task, and a forward-looking “what paperwork should I be filing for the final year of the trust when I get the money?” task.

Hurdle 9 – the recipient U.S. bank is happy?

Finally, you face one practical problem. You want to get the money out of the foreign trust in the foreign country, and into your bank account in the United States.

What happens when the U.S. bank sees a slug of cash hit your checking account from a foreign bank account that does not have your name on it?

This is a bank bureaucracy problem. Go talk to your banker. See what is required. It may be simpler than you expect.

If you run into problems, you will have to cast around for Plan B. I have no particular magic pill that will solve this problem. Poke around. Ask questions.

Can you open an account outside the USA at a bank that has U.S. branches (e.g., Citi, HSBC, Bank of America?). Probably not. You are radioactive, thanks to FATCA. But give it a try.

Can you migrate the trust to the USA (get a U.S. trustee) then terminate the trust once the move is complete? It might be hard. You’re asking the U.S. trustee to do a lot of work only to be immediately fired when the trust terminates and gives you the money.

Can you have the foreign trustee create a new U.S. trust in which you are a beneficiary and transfer the assets to that trust? Is this a metric ton of futile effort?

You get the idea.

But really. Your first and best bet is to talk to your banker. Things might turn out OK.

It’s not easy

Ever since the IRS started looking at everyone as “felon until proven otherwise” for foreign assets, the increased friction in the system has been considerable.

But you can do it. Be methodical, be polite. We have gone down this road many times. You can do it, too.

Disclaimer/warning shot

This isn’t legal advice. What I wrote here is just a step-by-step list of things that you should consider in unwinding your particular asset trust. The meta point is to be careful, have a systematic approach, and get professional help.

That’s it for this episode. See you in two weeks.