Is Domestic Asset Protection Still Viable After Mortensen?

Asset-protection planning using Domestic Asset Protection Trusts (DAPTs) just got a whole lot riskier after the recent Bankruptcy Court decision in Battley v. Mortensen. The Alaska court held that assets in an Alaska Asset Protection Trust were fair game for creditors, despite the fact that the trust's settlor was solvent at the time he formed and settled the trust. [Battley v. Mortensen, Adv. D.Alaska, No. A09-90036-DMD (May 26, 2011)].

The Facts

Thomas William Mortensen was an Alaska resident who settled a self-settled Alaska DAPT in 2005 for the benefit of himself and his heirs. He funded the trust with $80,000 in cash and property worth $60,000. After settling the trust, he accrued $250,000 in credit card debt, hospital bills, and debts stemming from bad investments.

In 2009, Mortensen filed for Chapter 7 bankruptcy. He didn't declare the DAPT's trust assets as part of his bankruptcy estate. The bankruptcy trustee became aware of the trust's existence and brought an action in Bankruptcy Court to set aside Mortensen's transfers to the trust as fraudulent transfers.

The trustee claimed Mortensen was insolvent at the time the trust was settled. The court disagreed. But the trustee argued in the alternative that Mortensen's settling of the trust was done with the intent to protect the assets from future creditors, opening up the trust to attack under the Bankruptcy Abuse Prevention and Consumer Protection Act ("BAPCPA") (the bankruptcy overhaul passed in 2005).

The Anti-DAPT Section of BAPCPA

Under Bankruptcy Code Section 548, the bankruptcy trustee has the power to void "any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if:

such transfer was made to a self- settled trust or similar device;
such transfer was by the debtor;
the debtor is a beneficiary of such trust or similar device; and
the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted."

In sum, a transfer within the last 10 years can be voided by the trustee "when property is transferred to a self-settled trust with the intention of protecting it from creditors." Mortensen argued that creation of the trust should not be viewed as evidence of a fraudulent transfer. The court disagreed, holding that the trust's express asset protection purpose could be viewed as evidence of fraudulent intent.

The voiding of transactions entered into with the purpose of defrauding current creditors is common in debtor-creditor law, but BAPCPA extends creditor protection by voiding transfers that were made with the intent to protect assets from future creditors.

Applying Section 548 to the Mortensen case, the court ruled the Alaska DAPT was void and that the trust assets were part of the bankruptcy estate. As a result, those assets could be liquidated to satisfy Mortensen's creditors—directly obviating the purpose for which the trust was formed.

The purpose behind most asset-protection strategies is to shield assets from future creditors. What now? Does Mortensen mean the end of asset-protection planning with DAPTs?

Solutions to the Mortensen Problem

First, Mortensen is just one case in one lower court. There's always the possibility that other courts won't interpret Section 548 so stringently. But regardless of whether we believe that other courts will apply Mortensen logic to other cases is irrelevant at this stage. Until another court considers DAPTs under similar circumstances (which may be many years from now), vigilant asset protection planning should internalize the lessons from Mortensen.

Second, there are countless ways to avoid the result in Mortensen with proper planning; although none has the power and simplicity of a self- settled DAPT. Looking to each of the five subparts of Section 548:

Section 548 applies only to transfers made within 10 years of bankruptcy. A bankruptcy filed more than 10 years after the trust is funded won't affect the trust (under Section 548). But 10 years is a long time to wait, and few clients will be interested in asset protection that takes that long to kick in.
Section 548 applies only to self-settled trusts. Trusts formed for the benefit of beneficiaries other than the settlor are out of reach of Section 548. For instance, a trust formed for the benefit of the settlor's children and not the settlor himself is not at risk under Section 548. Also, other forms of asset protection planning aren't affected by the decision. Life insurance is still—in most jurisdictions—the best asset protection device available.
Section 548 applies only when the debtor made the transfer to the trust. A transfer to a spendthrift trust by, for instance, the debtor's mother's estate without the debtor's direction is not susceptible.
Section 548 applies only when the debtor is the beneficiary of the trust. The settlor's creditors can't access trust assets via Section 548 if the settlor isn't a beneficiary of the trust.
Section 548 applies only when the debtor made the transfer in trust with the intent to hinder, delay, or defraud present or future creditors. If the transfer is made for some other purpose, it won't be a candidate for avoidance under Section 548. As always, the purpose of estate and asset protection planning techniques must be fully documented to avoid having the transaction reversed or ignored by the IRS or a court.

Conclusion

The era of the self-settled spendthrift trust may come to a close if other courts pick up on Mortensen. Advisors would be remiss if they don't discuss the risks of DAPTs with clients who need asset protection planning.

The result in Mortensen is clear: Domestic Asset Protection Trusts don't protect assets from creditors for the first ten years after the trust is settled. It might be time to look elsewhere for asset protection solutions.

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See also The Law Professor's blog at AdvisorFYI.