The average American has long viewed the use of foreign financial institutions to "shelter" assets with great skepticism. The release of the "Panama Papers" in April 2016 renewed the collective, latent distaste for such shelters, including the offshore asset protection trust (OAPT), which traditionally offered unparalleled protection from the claims of creditors. Because the laws of the individual states were, until recently, uniformly hostile toward self-settled asset protection trusts, domestic settlors often considered OAPTs to be the only viable asset protection vehicle available to them. Over the last two decades, however, 16 states have taken steps to create a statutory framework, which mirrors that of offshore jurisdictions by permitting self-settled, domestic asset protection trusts (DAPTs). (1) In addition to comparable asset safeguards, DAPTs in certain jurisdictions offer both tax and nontax advantages over their foreign counterparts. As a consequence, practitioners and settlors alike must consider whether the historic benefits of OAPTs currently outweigh the negative connotations, tax treatment, and compliance burdens intrinsic to such foreign trusts.
Asset protection trusts, domestic and foreign, are generally self-settled spendthrift trusts, i.e., trusts created for the primary purpose of protecting a settlor's own property from the claims of his or her creditors. Most DAPTs are classified as grantor trusts due to the settlor's retention of certain powers enumerated in I.R.C. [section][section]671 through 677. (2) Additionally, an OAPT settled by a U.S. person with U.S. beneficiaries will be considered a grantor trust--whether or not the settlor retained any of the aforementioned enumerated powers. (3)
Even though both DAPTs and OAPTs are considered grantor trusts under the code, their respective treatment by the Internal Revenue Service is substantially different, particularly in regard to the taxation of the trust's income and capital gains. By way of example, to the extent that distributions to DAPT beneficiaries carry out the trust's distributable net income (DNI) for the year, a DAPT will receive a deduction in calculating its taxable income. (4) Distributions of DNI to the beneficiaries of a DAPT will generally constitute ordinary income and will be taxed at the beneficiaries' applicable income tax rate. Unlike ordinary income, a DAPT's capital gains generally do not enter into the calculation of DNI. (5) In contrast, OAPTs must include ordinary income and capital gain in DNI. (6)
If an OAPT does not distribute every penny of its DNI in the current year, any after-tax portion of the undistributed DNI is considered undistributed net income under a set of provisions colloquially known as the "throwback rules." (7) The throwback rules treat the later principal distribution as being comprised of the previously undistributed DNI. This "accumulation distribution" is carried back to the beneficiary's earlier tax years in which the income was originally generated by the trust. (8) In effect, the throwback rules result in an income tax being levied at the OAPT beneficiary's highest marginal tax rate for the year in which the OAPT earned the income (or gain). As a result, any capital gains that the OAPT accumulated for distribution in a later year lose their capital character and are treated as ordinary income. (9) Further, the throwback rules add an interest charge to the distribution in order to offset any of the tax benefits that the taxpayer may have obtained by accumulating and not immediately distributing the OAPT's income. (10)
In addition to these substantive tax consequences, the reporting and compliance requirements are significantly higher for OAPTs. Prior to the enactment of the Small Business Job Protection Act of 1996 (SBA), (11) reporting was relatively nonexistent, as the penalties for failing to file the required returns amounted to approximately $1,000 per missed return, without regard to the size of the trust. (12) The SBA significantly increased the penalties for failure to report OAPT transactions. (13) Not only are the penalties exacting, but also the scope of required disclosure is extraordinary. The IRS requires disclosure even if providing such information would subject the OAPT's owner to penalties in the country where the trust is sitused due to that country's secrecy laws. (14)
In 2010, Congress enacted the Foreign Account Tax Compliance Act (FATCA) (15) to more comprehensively target noncompliance by U.S. taxpayers using foreign accounts to shelter assets. (16) FATCA opened the door for an OAPT to be treated as a "foreign financial institution." If an OAPT were so treated, remittances to it of "fixed or determinable, annual, or periodic" income would be subject to federal withholding taxes. (17) FACTA materially increased the SBA's compliance and reporting requirements due to the expanded scope of persons who might be deemed to have a reportable interest. (18) Importantly, the majority of the reporting requirements of FATCA and the SBA may be avoided if the OAPT is domesticated.
Although OAPTs have become subject to increasingly negative tax treatment and...