Introduction: There are two ways in which a creditor can attack an asset protection trust. The first is to hold the beneficiary liable for the debts of the asset protection trust, similar to a “piercing the corporate veil” attack made on a business entity. The second is to hold the asset protection trust responsible for the debts of a beneficiary, similar to “reverse piercing” of a business entity. (In this article the term “business entity” includes “corporations” and “limited liability companies” or “LLC” since each are statutorily recognized as entities separate from their shareholders or members, respectively.)
Self-Settled Trusts: This article focuses on attacks made on self-settled asset protection trusts formed under Wyoming law (“DAPT”). However, a threshold issue for anyone creating a self-settled DAPT is that, absent a state statute allowing the creation of a self-settled DAPT, a self-settled DAPT may not protect assets located in your home state if your state does not recognize them. Because your home state may attempt to short-circuit your asset protection trust (avoiding the need to pierce the veil or reverse pierce) a key part of your asset protection plan should be to avoid any connection between yourself and assets in your home state. Ultimately, if a creditor does not know that an asset is owned by your DAPT, they cannot take it from you.
When is Reverse Piercing Possible?: Almost every state has judicially established veil piercing and reverse piercing as creditor remedies in the context of business entities. The application of these remedies to a DAPT, however, varies from state to state. Reverse piercing is available to a beneficiary’s creditor in four situations: (i) the state does not have a DAPT statute; (ii) “funding,” i.e., transferring assets to the DAPT, was encompassed within the fraudulent transfer or voidable preference act (“UFTA”); (iii) the DAPT is being used to perpetuate a fraud or an injustice, or (iv) the DAPT is an “alter ego” of the beneficiary. This article addresses the third and fourth situations in the DAPT context.
DAPT as an “entity”: Piercing, reverse piercing, and alter ego attacks are judicially created methods of obtaining additional assets of a defendant when the defendant’s additional assets are held in a business entity. These methods are known as equitable remedies and a plaintiff can use them when the judge thinks the legal remedies available are insufficient or inadequate. The “limited liability” of a business owner is a “corporate privilege” that may be set aside as an equitable remedy if certain behavior is found by a judge.
A business entity is established by statute but a DAPT is not a business entity and is not actually an entity at all. Then what is a DAPT? Black’s Law Dictionary provides that a trust, including a DAPT, is a contract established at the request of a grantor appointing a trustee to hold property for a beneficiary. Thus, a DAPT is not considered to be an entity separate from the person who established it, but rather, a contractual relationship allowing designated individuals or entities only you those rights established under the trust agreement or contract.
Why, then, is the alter ego doctrine being applied in some states to a DAPT? It’s a mixed bag of logic.
California, in Greenspan v. LADT LLC (2010) 191 Cal.App.4th 486, provided a clear statement as to whether a self-settled trust, such as a DAPT, is an entity and, therefore, applied the alter ego doctrine against the trust:
Courts often speak of the alter ego doctrine as if it applied to a trust as an entity. But a distinction must be made between a trust and a trustee. The general rule that a trust is a relationship is universally recognized by U.S. cases and statutes and is consistent with the prevailing norms of the entire common-law world. The fundamental nature of this relationship is that one person holds legal title for the benefit of another person... [A] trust is not a legal person which [owns] property or enters into contracts... [T]he trustee... hold[s] title to the assets that make up the trust estate... Because a trust is not a legal entity, it cannot sue or be sued, but rather legal proceedings are properly directed at the trustee … A trust is simply a collection of assets and liabilities.
Because a trust is not an entity, it’s impossible for a trust to be anybody’s alter ego. That’s because alter ego theory, which is simply one of the grounds to ‘pierce the corporate veil,’ is inescapably linked to the notion that one person or entity exercises undue control over another person or entity. However, a trust’s status as a non-entity logically precludes a trust from being an alter ego.
This is inescapable logic; however, this does not escape the problem of a beneficiary’s creditors getting to a DAPT’s assets using an alter ego theory. The court then concluded:
While applying the alter ego doctrine to trusts is not legally acceptable, applying the doctrine to trustees is. Trustees are real “persons” under the law and it is entirely reasonable to ask whether a trustee is the alter ego of a beneficiary who funded the DAPT. This doctrine may, therefore, provide a viable legal theory for creditors absent the DAPT being found to be a separate entity.
Our conclusion is that your DAPT is not a legal entity; however, this may be a distinction without a different since your trustee may be so under your dominion and control as to allow reverse piercing of your DAPT using the alter ego theory.
Legal Findings: All the foregoing aside, many courts have applied the alter ego doctrine to an IRT to hold trust assets subject to the debts of the settlor or a beneficiary, whether by holding the IRT as a separate entity or by suing the trustee in its capacity as legal custodian of trust assets. The conclusion, below, will provide a method to assure this does not happen.
What are the Piercing and Alter Ego Tests: In the context of a DAPT, the settlor cannot amend, modify, or revoke the trust since it is irrevocable; consequently, the settlor no longer owns or controls trust assets and those assets are protected against the settlor’s creditors; however, the piercing and the alter ego doctrines may be used sparingly to stop an injustice in separating trust assets from recovery by a settlor’s creditors.
Piercing is generally based on fraud. The following is a list of the “badges of fraud”:
- no separate books of account for the corporation and its shareholders;
- corporate finances are not distinct from shareholder finances or obligations;
- the corporation is used to promote fraud or illegality;
- corporate formalities are not followed; or
- the corporation is a mere sham.
This is a “totality-of-the-circumstances test” that does not necessarily make any one of these badges essential to piercing, nor are these badges exhaustive.
Alter ego is different since it does not require a finding of fraud or injustice, although it is probable that one or more badges of fraud would have an impact if they exist. Alter ego is based on an individual so dominating the corporation that the corporation is merely an instrumentality of the individual. In this latter context, a Court would most probably try and find some element of bad faith; however, this is no required.
What Law Applies: Generally, the state in which the DAPT is established will govern the efficacy of the trust, and the laws of the establishing state will also apply to the implementation of the piercing and alter ego doctrines; thus, your trust instrument must select Wyoming as the governing law.
This is a general rule, and like most general rules, there are exceptions. A Court, given the facts of the case, may determine that a DAPT established in Wyoming by the resident of a state that does not have a DAPT statute has no legal efficacy and even if the trust does have vitality, the laws in the domicile of the settlor control the inquiry on piercing and alter ego. There has been one case from Washington involving an Alaska trust that set aside the trust and the funding, although the case has been roundly criticized and not followed in other jurisdictions; particularly since the finding ignored the U.S. Constitution’s “full faith and credit clause.”
If a Court outside Wyoming used its law to make judgments against the efficacy of your DAPT and/or used its laws in pierce, reverse pierce and alter ego to make your DAPT’s assets available to your creditors, would those judgments be honored in Wyoming? The full faith and credit Clause” ostensibly provides no, but just to make sure, Wyoming has adopted W.S. 4-10-507.1 titled “Enforcement of foreign judgments; liability for compliance,” which reads as follows:
(a) Notwithstanding any other provision of law, no judgment, decree or order of a court of the United States, a court of another state or any other court other than a Wyoming court shall be enforced against the property of any trust governed by the laws of this state unless a court of competent jurisdiction in Wyoming determines that the time, manner and mechanism for enforcing the judgment, decree or order is consistent with the restrictions and limitations imposed under this article for the enforcement of the claims of any creditor and is consistent with the terms of the trust. (b) A trustee, trust protector, trust advisor or other fiduciary of a trust, whether acting in a fiduciary capacity or not, shall not be liable for failing to comply with any judgment, decree or order of a court of the United States, a court of another state or any other court other than a Wyoming court that the trustee, trust protector or trust advisor believes in good faith to be inconsistent with the restrictions and limitations imposed under the terms of the trust or by this act.
Further, W.S. 4-10-107 was amended to provide the following:
(c) If the law of this state governs the meaning and effect of the terms of a trust in accordance with paragraph 13 (a)(i) or subsection (b) of this section, the trust and any transfer of property by a settlor to the trust, or any disposition made subject to the terms of the trust, shall not be void, voidable, set aside or deemed defective in any manner for any reason including: (i) That the law of a foreign jurisdiction prohibits or does not recognize the concept of a trust; or (ii) That the trust, transfer of property by a settlor to the trust, or disposition made subject to the terms of the trust avoids or defeats any forced heirship or legitimate right, claim or interest under the law of a foreign jurisdiction;. or (iii) That the law or public policy of a foreign jurisdiction does not recognize or limits the validity or enforceability of any or all the terms of the trust if the terms are valid and enforceable under the laws and public policy of this state.
In other words, Wyoming law applies as to the efficacy of the trust and to the reverse piercing and alter ego doctrines that apply. It is a permissible conclusion to find that absent a violation of UFTA, which, as circumscribed, is discussed in another article, would be the only claim a creditor would have, i.e., reverse piercing and alter ego do not apply, although that conclusion may be a stretch. Given the conservative nature of our Courts, it is doubtful whether any Wyoming court would entertain some of the more “liberal” interpretations of another state in this respect.
Conclusion: You have to assure compliance by your DAPT to preclude application of the reverse piercing and alter ego theories – if they apply. We have a full suite of solutions that provide you with just that. This will avoid the above inquires, and if it does not, the protocol will assure that a Wyoming Court applying W.S. 4-10-501.1 and 4-10-507 will hold your trust to be valid and your actions not to be subject to reverse piercing and alter ego – even if those doctrines do apply to a Wyoming DAPT.