Alter Ego: An Asset Protection Trust’s Achilles Heel?

Much has been written lately about Michigan’s recent venture into the asset protection trust waters with its adoption of the Qualified Dispositions in Trust Act (the Act) effective in March of this year. The Act clearly indicates that a transfer of assets into the Qualified Dispositions Trust can only be set aside following by the provisions of Michigan’s Uniform Voidable Transfer Act [the successor to the Uniform Fraudulent Transfer Act.] As such, the general view is that there are only a handful of remedies that are available to a creditor who wishes to challenge a debtor’s transfer of assets into a Qualified Disposition Trust. But what if, with hindsight, the Trust is treated as a non-entity? Will such a judicial finding that the Trust is a nullity, in effect lose the Act’s protections?

As a technical matter, a Trust is a fiduciary relationship and not a separate entity under the common law. Despite that technical distinction at common law, courts often treat an irrevocable Trust akin to a corporation, partnership, or LLC all of which are separate legal entities that are capable of holding title to assets. Based on the facts and circumstances a court might ignore the existence of that legal entity.

A judicial doctrine has evolved over the years to rectify perceived abuses or wrongs by debtors called the alter-ego analysis. This analysis is often coupled with a reverse-piercing doctrine that is based upon a finding of an alter ego. The alter-ego judicial analysis is that the legal entity and the person who formed that entity are so closely tied together, or that the person in reality so controls the entity without respecting the entity’s separate legal existence, that the person who creates the entity will be treated as the owner of the entity’s assets- in short, the legal entity will be ignored and treated as a nullity when a creditor seeks to levy and execute upon its assets to satisfy its judgment against the entity’s creator. The reverse piercing doctrine permits the entity creator’s personal liabilities to be imputed to the entity that was formed and to which his/her assets were transferred. Thus, the effect of applying the alter ego/reverse piercing analysis is that the legal entity will be completely ignored by the court when it seizes assets to satisfy a judgment.

While a Trust is technically a relationship and not a separate legal entity, courts have not been hesitant to treat an irrevocable Trust as a legal entity that is subject to the alter ego/reverse piercing judicial analysis and used to ignore the Trust and take its assets to satisfy claims against the settlor who formed and funded the Trust. One federal Michigan court decision, which followed the alter ego/reverse piercing judicial analysis, permitted the IRS to attach an irrevocable Trust’s assets to satisfy the unpaid tax liabilities owed by the Trust’s settlors. William L. Comer Family Equity Trust v. United States, 732 F. Supp. 755 (E.D.Mich. 1990). While a federal court’s interpretation of state law is not binding, often lower state courts will nonetheless give those decisions considerable weight. Could the alter ego/reverse piercing analysis be used by a Michigan court to find a Trust that was created under the Qualified Dispositions in Trust Act to be a nullity, and thus expose assets titled in the name of the Trust to satisfy the transferor’s creditors? Some might say ‘no’ by virtue of the Act’s clear references to exclusive remedies and by not mentioning the alter ego judicial doctrine. But if the Trust is void ab initio, then the Act would not apply, despite its exclusive remedy restrictions.

Admittedly Michigan’s Act goes to great lengths to protect transfers that are made to a Qualified Disposition Trust, intentionally placing many procedural and litigation hurdles that a creditor must overcome in order to be paid from the Trust’s assets. Even if a creditor successfully obtains a court order to compel the payment of Trust assets to satisfy the creditor’s claim, the Trust continues as a viable relationship/entity according to the Act. But if the Trust is treated as a nullity from the outset arguably the Act and its exclusive remedies and all of its other protections will not apply. This is not what the Act’s drafters intended, but that might be the outcome if the alter ego/reverse piercing analysis trumps the Act’s specific provisions.

That could be the outcome following a recent Nevada court decision. In that case a Nevada federal court held that the judge can pierce Nevada Trusts to satisfy a judgment against the husband of the wife who created the Trusts, applying the alter ego/reverse piercing judicial doctrines in Transfirst Group, Inc. v. Magliarditi 2017 WL 2294288 (D. Nev., May 25, 2017) A $4.0 million judgment was entered against Mr. Magliarditi in a Texas federal court. The legal proceedings moved to Nevada where the plaintiffs attempted to collect their judgment against Mr. Magliarditi. LLC’s, partnerships, and Trusts had been created by Mrs. Magliarditi using assets that she received when she and her husband divided their Nevada community property. All these entities, including the Trusts, were viewed by the federal judge, applying Nevada law, as subject to an alter ego analysis: “Nearly every court to have addressed the issue…has concluded that alter ego liability should apply to trusts to the same extent it applies to other legally created fictions.”

Nevada has a very strong LLC statute that provides the exclusive remedy to enforce a judgment against the LLC member is a charging order. Notwithstanding that statute’s effort to narrow the remedies available to a judgment creditor to a charging order, the judge found that the plaintiff did not seek to satisfy its judgment out of the member’s interest in the LLC [which would respect the legal entity], rather plaintiff asserted the LLC was a sham and thus essentially a non-entity, and thus the LLC statute’s exclusive remedy charging order prohibition was inapplicable. Arguably a successful alter ego analysis applied to a Qualified Dispositions Trust could have the effect of the judge finding that no trust exists.

To apply the alter ego analysis, the judgment creditor has to prove: (i) the Trust was de facto influenced and governed by the person asserted to be its alter ego; (ii) there such a unity of interest and ownership such that the person and alleged alter ego ( the Trust) were inseparable; and (iii) adherence to the fiction of separateness of the Trust would, under the circumstances, sanction a fraud or promote injustice.

The judge spent considerable time looking at Mrs. Magliarditis’ entities and the Trusts. While the Magliarditis converted their community property to separate property pursuant to a transmutation agreement, the judge found that Mr. Magliarditi did not have to own the alleged alter ego entity for his judgment creditor to be able to proceed against that entity. The judge found that the assets Mrs. Magliarditi had transferred to the Trusts were still controlled by her husband- that she was clueless with what he did with the assets titled in the names of the Trusts, or how the assets were invested by her husband, even though he was not the named trustee. Mr. Magliarditi also used funds held in the Trusts, LLCs and partnerships that had been formed by his wife, to pay for his personal expenses, e.g. flying lessons, and gym memberships, and to maintain two homes that he occupied, one in Las Vegas and the other in southern California, all the while claiming that he was insolvent. Undocumented loans were also made from these entities to Mr. Magliarditi, but few records were kept to show deposits or withdrawals. From these admittedly bad facts the judge easily found that Mr. Magliarditi had virtually unfettered control over substantial assets held in the Trusts and that Mrs. Magliarditi had enabled her husband’s efforts to evade the judgment against him. The judge found that Mr. Magliarditi had transferred his assets into alter ego entities, including the Trusts, to evade his creditors and that he attempted to shield those assets as his wife’s separate property while he retained control over the assets held in the name of the Trusts and personally used those same assets. In sum, the Nevada Trusts were subject to alter ego/reverse piercing analysis despite the creditor protections afforded by Nevada’s laws, including one of the nation’s most protective asset protection trust acts.

Whenever an irrevocable Trust is, to be kind, loosely administered or its structure is ignored, or the trustee permits unfettered access to and use of its assets, there exists the risk that a judge will completely ignore the Trust by applying the alter ego/reverse piercing analysis, regardless of whatever the state’s asset protection statute provides to the contrary. While a resident individual can serve as a qualified trustee of a Michigan Qualified Dispositions Trust, the concern over a judge wielding an alter ego/reverse piercing analysis is strong enough reason to use a professional trustee that will administer the Trust instrument as it is written, not make unsecured loans to beneficiaries, and which is far less likely to be as clueless as Mrs. Magliarditi. Along the same lines, individuals who contemplate the use of a Qualified Dispositions in Trust need to fully understand the control that they are going to give up over the assets that they plan to transfers to a qualified dispositions trust- there can be no prior arrangements or understanding that the transferred assets will always be readily available to them.

We will have to wait for a Michigan court to tell us whether the Qualified Dispositions in Trust Act’s exclusive remedy provisions actually trump a judge’s equitable power based on facts and circumstances to apply an alter ego/reverse piercing analysis to negate the existence of the Trust. This is just one of the many unanswered questions that will have to be answered over time with Michigan’s version of a self-settled asset protection trust.