“Properly- Structured” Self-Settled Trusts Formed by Nonresident Settlors Will Withstand Legal Challenge

“Properly- Structured” Self-Settled Trusts Formed by Nonresident Settlors Will Withstand Legal Challenge

This treatment hypothesizes a scenario where a nonresident settlor, with no existing or foreseeable creditor obligations, establishes a  self-settled discretionary spendthrift trust in a state with statutes authorizing the creation of such trusts. The settlor’s spouse and two children, all living together, are the absolutely discretionary beneficiaries. The trust authorizes the trustee to name the settlor as a beneficiary in the future. Years later, a claim arises against the settlor from unforeseen, but conceivable events.

The question presented is: “Will the trust survive a court challenge?”

It can be presumed that the plaintiff believes his prospects for success are greater in the settlor’s home state, which arguendo prohibits self-settled trusts than the trust state, so he is likely to sue in the settlor’s home jurisdiction; however, it is posited that neither a court in the settlor’s state of residence, or a sitting federal district court will have jurisdiction over the trust, as distinguished from the plaintiff personally, because the trustee only has incidental contact with the settlor’s resident state and does not purposely avail itself of the benefits of doing business in the state. If the local court were to bootstrap jurisdiction, it is unlikely that the trust state’s courts will enforce a full faith and credit challenge to the trust due to the local court’s lack of jurisdiction, the minimal relationship of the settlor’s home state to the trust and the trust state’s public policy favoring SSDS Trusts. Consequently, the sole venue for original jurisdiction likely will be a federal bankruptcy court sitting in the settlor’s state of residence, which generally will require an involuntary bankruptcy petition.

Since the facts do not involve a fraudulent transfer of assets into the trust, the duty of the bankruptcy court will be to make a choice of law determination based on which state – the trust state or the settlor’s resident state – has the most substantial relationship to the trust. Under the facts presented in the hypothetical Model Trust, a preponderance of the nexus factors favors the trust state; therefore, it can be presumed that the law of the trust state will prevail and the trust will be validated.

Defenses to Challenge

Although self-settled trusts historically were not favored by the states, they are now authorized in 16 states. Notwithstanding widely different state public policy views, a nonresident settlor can expect that either: (1) jurisdictional limitations, (2) the plaintiff’s lack of full faith and credit enforcement arguments, (3) the designation in the trust instrument of the trust state law to govern; or (4) the trust state’s “substantial relationship” to the trust will thwart the creditor’s suit, allowing the trust to survive intact. This may come as a surprise to planners and attorneys not familiar with the nuances of this type of trust.

Faced with financial stress, some planners and their clients have launched desperation SSDS Trusts that were bound to fail. Typically, there is a “Hail Mary” fraudulent transfer attempt, with the trustee domiciled in the SSDS Trust state, but little else existing to connect the trust to the trust state. In response, the courts have often searched for ways to render equitable relief, muddying the waters for well-designed plans.A primary goal of this Commentary is to differentiate the good from the bad, thereby, providing a fact-based guideline for practitioners seeking legitimate benefits for their clients who don’t live in a SSDS Trust-enabled state.

To date, no court has adjudicated whether a creditor may reach the assets of a properly designed and implemented domestic SSDS Trust. However, quoting an article by Fogel, “the long and short of this discussion is… the only means of enforcing a judgment against such a domestic asset protection trust may be to attack the creation of the trust as a fraudulent transfer. Whether or not the post transfer creditor will be successful will likely depend on whether the particular creditor was a contemplated creditor at the time of the transfer.”

Paths to Survival

There are five (5) paths leading to the survival of a SSDS Trust based on the Model Trust, as outlined in the Commentary. Likely, only one path need succeed for the trust to prevail:

  1. A court in the settlor’s state of residence denies jurisdiction to the plaintiff after determining that the trust state has legal jurisdiction over the matter due to the location of the trust and trust assets in the trust state and the trustee’s “minimum contacts” with the state court.
  2. Arguendo, the local court bootstraps jurisdiction and renders a judgment invalidating the trust. Under the Full Faith and Credit Clause, the trust state’s strong public policy in favor of such trusts likely will cause its courts to deny enforcement of the nonresident settlor court’s judgment if the trust is found invalid on the sole ground the settlor can be added in the future as a beneficiary. Such a prospect may even encourage the plaintiff to withdraw the suit.
  3. The settlor is able to avoid involuntary bankruptcy, leaving the plaintiff without a jurisdictional venue in which to complain.
  4. A federal bankruptcy court validates the trust by applying the law of the trust state due to that state’s more substantial relationship to the trust than the local court, based on Restatement (Second) § 270
  5. A federal bankruptcy court determines the trust’s terms are enforceable against a creditor, based on Restatement (Second) § 273.

There are compelling reasons for a nonresident settlor engaged in trust planning to consider a self-settled discretionary spendthrift trust – privacy, fear of a future financial reversal, potential tax benefits, fear of an unfounded claim, flexibility to modify the trust if circumstances change, avoidance of intra-family quarrels and a host of others. While the legal sustainability of a properly structured and implemented SSDS Trust with a nonresident settlor remains untested in court, a preponderance of the evidence and scholarly comment points toward the trust’s survival. From a practical viewpoint, it can be said that a trust structured like the Model Trust will have proven its worth if it provides real benefits to the settlor and either: (1) is sustained or (2) if a dispute arises, leads to an attractive settlement.

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