Asset Protection Trusts: Better than a Prenuptial Agreement?

Take-Away: After a relatively ‘dubious’ history of success in the courts over the past few years, there is now one ‘successful’ published court decision with regard to the effectiveness of an asset protection trust. This reported decision comes out of Nevada. While 17 states, including Michigan, have some form of asset protection trust, there persists the concern that these trusts may not be respected under the ‘full, faith, and credit’ clause of the US Constitution if a self-settled asset protection trust runs contrary to another state’s strong public policy. The primary problem is there usually is no single repository of a state’s public policy, and courts are free to find (or to ignore) sources for any claimed public policy that suits a judge’s purpose.

Background:

Asset Protection Trusts: In early 2017 Michigan adopted its version of an asset protection trust with its Qualified Dispositions in Trusts Act. [MCL 700.1041, et. seq.] Thus, it is no surprise that the effectiveness of Michigan’s asset protection trust legislation has not yet been tested in the courts. But the mere presence of the Act is a good indication of Michigan’s public policy in favor of a self-settled asset protection trust and when such a trust can provide a protective cloak to the assets of an individual.
Public Policy Exception?:That being said, I wonder if Michigan’s courts have a good understanding of this ‘new’ manifestation of Michigan’s public policy in light of the two 2017 Allard decisions (Allard v Allard, 318 Mich App 583 (2017) which held that the spouses’ prenuptial agreement that identified their separate property interests could be cavalierly ignored by a divorce court in light of Michigan’s express public policy, as manifested in its earlier statutes that permit a divorce judge to award one spouse’s separate property to the other spouse in an equitable division of their assets. One possible take-away from the Allard decisions is that a prenuptial agreement executed in Michigan, in an effort to protect premarital or inherited separate property assets in the event of a future divorce, is of dubious legal effect. However, it is hard to reconcile Allard’s reliance on a finding of a strong statement of Michigan’s public policy premised on divorce statutes enacted in the 1950’s, in the face of the 2017 Michigan Qualified Dispositions in Trust Act which expressly directs that a divorce court cannot divide the assets held in the asset protection trust set up by one spouse more than 30 days prior to the marriage, nor under the Act can the divorce judge take into consideration, directly or indirectly, the assets held in the trust in the division of marital assets or when setting a spousal support award. At best, there is real confusion with regard to Michigan’s public policy these days when it comes to protecting premarital and inherited assets in the event of a divorce, particularly if those assets are held in an asset protection trust.
Huber Decision Cloud: The effectiveness of asset protection trusts was first questioned in a Bankruptcy Court decision, In re Huber, 493 B.R. 798 (W.D. Wash. 5/17/2013). In that decision an Alaskan asset protection trust, governed by Alaska’s laws, was successfully challenged by a bankruptcy trustee when the settlor later filed bankruptcy. The irrevocable trust was attacked using a conflict of laws analysis. The Bankruptcy Court found few contacts the Washington state settlor had with Alaska, coupled with Washington’s ‘strong public policy against self-settled trusts’ which caused the court to bring the asset protection trust’s assets into the bankrupt’s estate. In short, Washington’s strong public policy against self-settled trusts trumped Alaska’s express asset protection trust legislation. This well-publicized decision cast a cloud on the possible success of an asset protection trust in fending off creditor claims, especially in those situations where the trust’s settlor lived in a state that did not favor or legislatively acknowledge asset protection trusts- in short, in a state where the settlor was likely to be sued by his or her creditors. This choice of law vs. strong public policy debate was repeated in Dahl v Dahl, 2015 WL 5098249, 794 Utah Adv. Rep. 5, 2015 (August 27, 2015) where a Utah divorce court ignored a spouse’s interest in a Nevada asset protection trust on the basis of ‘Utah’s strong public policy favoring equitable distribution of marital assets.’ But the Dahl decision might also be distinguished not so much on Utah’s public policy against such trusts, but upon language that was used in the Nevada trust (a mistake? a scrivener’s error?) in which the settlor husband clearly retained the power to alter or amend the terms of the asset protection trust, thus making the trust a revocable grantor trust which the Utah court easily seized upon to use the trust assets, available to the husband, as part of its property division.

Along Comes Klabacka: In 2017 the Nevada Supreme Court upheld the validity of an asset protection trust established under Nevada’s statute in the context of a divorce. Klabacka v. Nelson, 394 P.3d 940 (May 25, 2017.) The facts were pretty straight-forward. The Klabackas never signed a prenuptial agreement. Rather, the Klabackas entered into a postnuptial separate property agreement in which they divided their community property interests between the two of them (Nevada being one of the handful of community property jurisdictions.) They then took their newly created separate property assets and funded their respective estate planning trusts. Later they each converted their respective estate planning trusts to Nevada asset protection trusts established under Nevada’s asset protection trust statute. The Klabackas later found themselves in divorce court, where Ms. Klabacka petitioned the divorce court to invade the assets held in Mr. Klabacka’s Nevada asset protection trust in order to ‘equalize’ their respective trust assets and to use the assets held in Mr. Klabacka’s asset protection trust to pay Ms. Klabacka’s spousal support and child support awards. The appellate court found that the Nevada statute prevented the trial court from accessing Mr. Klabacka’s trust assets to equalize the two asset protection trusts. In addition, the court held that the Mr. Klabacka’s asset protection trust, due to its spendthrift clause, could not be used to satisfy his court ordered support obligations to Ms. Klabacka.

In its decision, the Nevada Supreme Court observed that the two Nevada asset protection trusts were established for the protection from creditors ‘and not for the purpose of a property settlement in the event of a divorce.’
While the Klabacka decision does not address the concern created by Huber that courts in states that do not have asset protection trust statutes may not feel bound to enforce an asset protection trust established by one of its citizens in another state, the Kalbacka decision does provide some helpful precedent that the existence of the asset protection trust statute manifests an accurate and contemporaneous example of that state’s public policy that limits a divorce court’s access to assets held in the trust.

Prenuptial Agreement v. Michigan Asset Protection Trust: Which brings us to the question, what is better: entering into a prenuptial agreement to protect premarital and inherited property, both of which are presumed to be an individual’s separate property under Michigan’s equitable distribution statutes, or adopt and fund a trust under Michigan’s Qualified Dispositions in Trust Act using those separate property? As noted earlier, the Allard decisions cast a real cloud over whether a prenuptial agreement will be enforced by a Michigan divorce court, or if it will be ignored if the ‘equities’ before the court, i.e. what the judge thinks is fair, compel the divorce judge to invade the other spouse’ separate property despite what their prenuptial agreement said was to be left untouched in the event of a divorce. While there is a bill lingering (somewhere) in Lansing that would reverse the implications of the three Allard decisions, it is debatable if the state Legislature will ultimately agree that the Allard decisions went too far in finding the state’s public policy in its divorce empowerment statutes, while conveniently ignoring the relatively recent state public policy as manifested in the adoption of the Qualified Dispositions in Trust Act. Several reasons may exist for an individual to establish an asset protection trust on the eve of a marriage, which include:

No Emotional Negotiations: Negotiating a prenuptial agreement is always delicate and emotional, as it forces the individuals to address the prospect of a divorce even before they are married. Business and money trump love in these awkward negotiations. With an asset protection trust that is adopted and funded at least 30 days prior to the marriage, there is no need for the two individuals to engage in ‘negotiations’ with one another and reach a formal agreement that contemplates their future divorce;
No Financial Disclosures: For a prenuptial agreement to be presumptively valid, there must be a full and fair disclosure of each party’s assets and debts, with a reasonable value attached to most assets, so that the waiver of rights contained in all prenuptial agreements is knowingly made. The ‘full and fair’ disclosure is often a frequent basis on which to challenge the validity or enforceability of a prenuptial agreement. With an asset protection trust there is no precondition of full disclosure of assets and debts, only that the trust be created and funded at least 30 days before the marriage;
No Separate Property Invasions: As the three Allard decisions graphically exhibit, despite the provisions of a prenuptial agreement where separate property assets were identified and covenants made to not claim any interest in them in the event of a divorce, a divorce judge can always find reasons, or ‘changes in circumstances’ between the agreement’s adoption and the later divorce, to invade the separate property of one spouse for the benefit of the other spouse. In contrast, the Qualified Dispositions in Trust Act makes it very clear that a divorce just is directed by the Act to neither directly or indirectly divide the trust’s assets nor to directly or indirectly take the trust into consideration when the marital estate is to be divided. In effect, the divorce judge will have no jurisdiction over the asset protection trust or its assets, and the fact that one spouse is the lifetime beneficiary of the asset protection trust is not to be considered by the judge when dividing the marital estate [although it remains to be seen how one goes about proving what the judge ‘considered’ when the judge departs from a 50%-50% division of the marital estate.]
No Equitable “Hair-Splitting:” While an individual’s separate property is not supposed to be subject to a division of wealth in a divorce in Michigan, over the decades several ‘exceptions’ have been created by the courts to this general rule. Assume, for example, that a spouse inherits wealth and holds that inherited wealth in a revocable grantor trust to isolate those inherited assets so as to not commingle them with marital assets. Notwithstanding that effort to segregate those inherited assets in a revocable trust, a divorce court can still access those trust assets when: (i) the other spouse has demonstrable need that cannot be met with his/her share of the marital estate; or (ii) the growth in those separate property assets was due in part to the active appreciation of those inherited assets [the term active appreciation not being well defined- is watching Jim Cramer every night on CNBC for investment advice sufficient ‘activity’ to warrant a finding of active appreciation that permits the inclusion of the appreciation of the separate property in the marital estate? ] With an asset protection trust, again the direction to a divorce judge that he/she cannot indirectly divide the trust assets, which seems to be a legislative effort to prevent divorce courts from fashioning clever equitable remedies to access assets that are intended to be fully protected from the claims or creditors or irate spouses.

Conclusion: In some respects, it seems that using a Qualified Dispositions in Trust instrument to hold assets in the event of a future divorce is overkill of the mechanism, especially if other conventional creditors are not all that much of a concern. Yet with all the uncertainty swirling around the viability of prenuptial agreements in Michigan caused by the Allard decisions, an asset protection trust may be the best way, at present, to protect an individual’s separate property [acquired prior to the marriage; gifts; inheritances] from both conventional creditors and divorcing spouses. It’s at least an option to consider these days when the effectiveness of a prenuptial agreement is so suspect.