Asset Protection Trusts: A Second Look at the Alter-Ego Concerns

Take-Away: I wrote recently that there may be a back-door approach to attack a Michigan Qualified Dispositions in Trust if a creditor asserts that the Trust is nothing more than the alter-ego of the Trust settlor. A highly respected commentator recently concluded that such an attack based on alter ego judicial equitable remedy may not be viable, despite what a federal judge in Nevada recently concluded.

Background: We know that Michigan now has a statutory scheme that expressly permits a person to create a self-settled asset protection trust. That statutory scheme goes to great lengths to limit the remedies available to the creditors of the trust settlor, often using terms like ‘sole remedy’ or ‘exclusive remedy.’ A recent Nevada case addressed Nevada’s asset protection trust legislation, which is even more protective of the settlor’s assets than Michigan’s asset protection trust statute. In that case the federal judge applied what is known as the alter-ego or reverse alter-ego equitable remedy to take assets from an irrevocable trust and use those asset to pay the judgment creditors of the trust settlor’s husband. The federal judge held that this judicial equitable remedy could be used to attack an irrevocable trust, even though the alter-ego remedy has historically only applied to corporations, and the reverse-piercing/reverse alter-ego remedy applied to partnerships and limited liability companies,  if it appears that the assets transferred to the trust were intended to defraud creditors. In short, by applying an alter-ego equitable remedy, the federal judge was able to completely circumvent  Nevada’s very favorable asset protection statutes. After reading that court decision I then raised the rhetorical question if there were enough ‘bad facts’ that surround the administration of a Michigan Qualified Dispositions Trust,  a Michigan judge might follow the Nevada judge’s lead and find that the Qualified Dispositions in Trust was subject to attack by a judgment creditor on the basis that the irrevocable trust was simply the alter-ego of the trust’s settlor and pierce the trust and take its assets to satisfy the judgment creditor of the trust’s settlor.

Alter-Ego Remedy: A common situation  where the alter-ego judicial equitable remedy is applied to access assets is where asset are transferred by the judgment debtor to a separate legal entity, e.g. a corporation, yet the asset transferor-debtor continues to treat the assets as his/her personal assets, e.g. he uses them without compensation to the entity; he commingles the transferred assets with his own personal assets; where the transferred assets are not formally titled in the name of the transferee;  or, where the formalities of the entity owning those transferred assets are completely ignored and it is impossible to identify what assets are actually owned by the entity. These were the types of  ‘badfacts’ that the Nevada judge looked to in applying the alter-ego equitable remedy to take assets from the wife’s irrevocable trust and make those assets available  to the husband’s judgment creditor [about $3.0 million in assets.][Note that the assets were originally the husband’s. He made lifetime unlimited marital deduction gifts of those assets to his wife. His wife then used those gifted assets to fund the irrevocable trust and limited partnership interests held in the trust.]

One Michigan Case: There is only one reported Michigan case, William L. Comer Equity Trust v. United States, 732 F. Supp. 755 (E.D. Mich. 1990] where a judge applied the alter ego remedy to access assets held in an irrevocable trust to satisfy the income tax liabilities of the trust settlor. In doing so the judge noted in his decision: “While the Court uncovered no precedent analyzing the ‘alter ego’ theory of property ownership in the context of a trust, cases involving corporate entities provide appropriate guidance.’

Other States: Only the California Supreme Court has expressly held that the alter-ego remedy can be applied to an irrevocable trust. There have been other cases where this result was reached, but those decisions were all lower court decisions that often carry little precedential value when guiding estate planners.

Second Look: Noted legal commentator Richard Nenno of Delaware concludes ‘not so fast’ when estate planners become distressed that a future court might circumvent the ‘sole remedy’ limiting language often found in asset protection trust statutes with a finding that the irrevocable trust is the alter-ego of the trust’s settlor [or in the Nevada case, the wife was the trust settlor, yet the judge found that her trust’s assets were available to satisfy the judgment against her husband.]

Trustees but not the Trust: Mr. Nenno refers to the California court decision for the proposition that the alter-ego judicial remedy should not apply to an irrevocable trust, but it may be applied to and imposed on trustees:

“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. But while applying alter ego doctrine to trusts is conceptually unsound, applying the doctrine to trustees is a different proposition. Trustees are real persons, either natural or artificial, and, as a conceptual matter it is entirely reasonable to ask whether a trustee is the alter-ego of a defendant who made a transfer into the trust. Alter-ego doctrine can therefore provide a viable legal theory for creditors vis-à-vis trustees, its entirely reasonable to ask whether a trustee is the alter ego of a defendant who made a transfer into the trust.”

The thrust of Mr. Nenno’s reasoning is that in Delaware no court has ever recognized piercing a partnership to gain access to its assets or pierced an irrevocable trust. Moreover, Delaware has expressly declined to impose the legal theory of reverse-piercing to take the assets of an entity to satisfy a judgment against a third party. He thus concludes that it is a gigantic stretch for judges to access the assets held in an irrevocable asset protection trust, at least in Delaware, especially where there exists a state statute that uses phrases like ‘sole remedy’ or ‘exclusive remedy’ as a strong indication of a state’s public policy on this issue of protective trusts.

Conclusion:  Three concluding thoughts.

1. It is always important to remember that a trust is a legal relationship, not a legal entity, so analogies to limited liability companies, partnerships and corporations when addressing the alter ego remedy often is misplaced. This misconception about irrevocable trusts as a separate legal entity regularly appears in newspaper articles, and sadly from time to time in probate courts where the judge tends to treat the trust like a corporation. They are different, as is the legal principles upon which each is based, and therefore different legal remedies need to be applied based upon the unique nature of the entity or relationship.
2. Delaware’s laws that protect legal entities, including trust relationships, is very well defined, with multiple favorable court decisions [in contrast to Michigan which seems inclined to avoid issuing published decisions that carry precedential value] which may be a good reason, if a client is considering the adoption of an asset protection trust, to use Delaware’s statute over Michigan’s Qualified Dispositions in Trust Act. This is just one more reason why Greenleaf Trust was motivated to obtain trust powers in Delaware, to provide our clients better options for their estate plans.

It is far less likely that a court will be inclined to apply an alter-ego remedy to an irrevocable trust if a professional corporate trustee administers the trust, since the likelihood of a person/beneficiary personally using trust assets without paying compensation or rent, or commingling trust assets with personal assets, or arguably transferring assets to the trustee without formal documentation of a change in title,  is far less likely to occur with a professional trustee that administers the trust. Personal use of transferred assets,  commingling of trust and personal use assets, and inadequate adherence to formalities,  are the proverbial ‘bad facts’ most likely to precipitate an alter-ego argument by a judgment creditor accepted by a judge.