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June 8, 2017

An Overview of Michigan’s Qualified Dispositions In Trust Act

Why it is relevant: The draft persons of the proposed bill, which ultimately became the Michigan Qualified Dispositions in Trust Act [MCL 700.1041 et. seq.] thought that the Act could possibly result in a business boom for estate planning attorneys and trust companies in northern and western Michigan. Their reasoning was based on the notion that many wealthy residents of Illinois, Indiana, and Wisconsin who have Michigan summer homes would be willing to travel here to create their asset protection trusts (for convenience referred to as an APT), since neither of those states has comparable legislation.

Key Features of the Michigan Qualified Disposition in Trust Act (the Act):

  1. Replaces Common Law: The Act expressly replaces Michigan’s historic common law that prevents a self-settled irrevocable trust as a mechanism to defeat the settlor’s creditors. MCL 700.1049(2) overrides that common law expressed in In re Hertzberg Inter Vivos Trust, 457 Mich. 430 (1998).
  2. Settlor’s Retained Rights: The Act permits a settlor to retain several enumerated rights in an asset protection trust but prohibits the settlor’s creditors’ access to the APT assets. Those permissible retained powers include the right to:
    • control investments
    • veto distributions by the trustee
    • receive trust income
    • receive, pursuant to the trustee’s exercise of discretion, trust principal
    • withdraw 5% of the APT assets each year
    • remove and replace an acting trustee
    • receive income to pay income taxes attributable to the settlor, i.e. a grantor of an APT
    • have the APT pay the settlor’s debts and administration expenses on the settlor’s death; and
    • have the APT pay the settlor’s estate tax liability [IRC 2036 or 2038 will cause estate tax inclusion]. MCL 700.1044
  3. Michigan Trustee: The APT must use at least one Michigan domiciled trustee.
  4. Michigan Law: The APT must be governed by Michigan law as to its validity and construction.
  5. Spendthrift Limitation: The APT must contain express spendthrift language: “the interest of the transferor or other trust beneficiary in trust property may not be transferred, assigned, pledged, or mortgaged, whether voluntarily or involuntarily, before the qualified trustee or qualified trustees actually distribute trust property to the trust beneficiary, and (this) provision of the trust instrument is considered a restriction on the transfer of the transferor’s beneficial interest in the trust that is enforceable under applicable non-bankruptcy law within the meaning of section 541(c)(2) of the bankruptcy code.”
  6. Limited Exception Creditors: There are only two exception creditors who are authorized to attach assets held in the APT – (i) claimants for child support arrearages, if the arrearage exists more than thirty (30) days at the time of the transfer to the APT – in that case the transfer is not a qualified transfer to the trust; and (ii) the transferor, or any person who is related or subordinated to the transferor is acting as an advisor, a specific term defined in the Act. As a comparison, the Michigan Trust Code’s support trust statute identifies exception creditors those who possess the right to access the debtor-beneficiary’s interest in the trust: child support claimants, spousal support claimants, governmental agency claimants, and those claimants who provided services to the support trust that enhanced or protected the beneficiary’s interest in that trust. [MCL 700.7504(1)] In other states’, APT statutes may include creditors who possess preexisting tort claims against the transferor.
  7. Short Statute of Limitations: A short two (2) year statute of limitations applies to claims filed to set aside transfers to an APT. The statute of limitations for claims brought by a creditor under the Michigan Fraudulent Transfer Act or Voidable Transfer Act is normally six (6) years. MCL 1045(3)(i).
  8. Limited Remedies: The sole remedies available to a creditor who wishes to attack a transfer to the APT are specified limited remedies that are provided under the Michigan Fraudulent Transfer Act or Michigan Voidable Transfer Act. Accordingly, a judge’s resort to equitable remedies to set aside a transfer to an APT is foreclosed by the Act. MCL 700.1045(2)(a) and MCL 700.1047.
  9. High Burden of Proof: The burden of proof imposed on a creditor who challenges a transfer to the APT is high. The creditor must show by clear and convincing evidence the transferor’s insolvency and the transferor’s actual intent to hinder, delay or defraud that specific creditor (not another creditor.) MCL 700.1045 (b)(2).
  10. Divorce Protection: If the APT is established over thirty (30) days prior to the transferor’s marriage, the divorce court is directed to neither directly, nor indirectly, divide the APT’s assets, or to directly or indirectly take the APT into consideration when the marital estate is divided. Transfers to the APT during the marriage can also be protected if the non-transferring spouse agrees that the transfer is a qualified transfer. MCL 700.1045 (4)(a)(b).
  11. Affidavit of Solvency: Each time an asset is transferred to the APT the transferor must sign a qualified affidavit that reflects that the transferor possesses good title to the asset, authority to transfer the asset, that there is no intent to defraud a creditor by the proposed transfer, that the transfer will not render the transferor insolvent, that the transferor has no knowledge or reason to know of any pending litigation, that the transferor is not 30 or more days behind in child support, and that the transferred asset is not a product of illegal activity. MCL 700.1046 (1). Some other states’ APT statutes do not require any affidavit from the transferor.
  12. Successful Creditor: If a creditor successfully challenges the APT, the court may only authorize a distribution from the APT sufficient to satisfy the creditor’s claim – back to the transferor, not directly to the creditor. It is then up to the successful creditor to recover the asset from the transferor. The APT otherwise remains intact after that distribution. Moreover, the success of one creditor cannot be utilized by another creditor. Thus, if one creditor successfully proves that it was intentionally defrauded by the transfer into the APT, other creditors will have to prove that they were intentionally defrauded – there is no piggy-backing onto another creditor’s successful challenge of a transfer to the APT.
  13. Advisors and Trustees Protected: Lawyers who advise a client to adopt an APT, or the Trustees who serve under an APT, are explicitly exonerated from liability for claims that might otherwise be based on a legal theory of aiding and abetting. MCL 700.1045 (7). Interestingly, the Act directs a trustee to ignore and implicitly affirmatively challenge any assignment or other action that contravenes the protection that is intended by the Act for the APT beneficiary. MCL 700.1049(3)
  14. Entireties Protection: Spouses can create an APT and transfer their entireties owned assets to that APT. While title to the asset is held in the name of the trustee it is still treated as owned as tenants-by-the-entireties. If a creditor successfully attacks a transfer to the APT, the court is directed to transfer entireties owned assets back to the spouses by the entireties. This rule is intended to frustrate the successful creditor if their claim is against only one spouse. MCL 700.1047(6).
  15. Last-In, First-Out Rule: The Act is drafted so that if a trustee is ordered by a court to disgorge APT assets to satisfy a claim of one successful creditor, the assets to be distributed are those that were most recently transferred into the APT. This rule is intended to retain the assets initially transferred to the APT as long as possible in the APT so as to protect them with the two (2) year statute of limitations which controls subsequent challenges to transfers to the APT.

Unlikely Candidates for an APT:

  1. Non-High Risk Clients: Folks like retirees, whose most dangerous activity is driving a car, are not likely candidates to adopt an APT.
  2. Entireties Property: Husbands and wives who own their assets as tenants by the entireties are probably not good candidates for an APT unless both of them are engaged in the same high risk activity. Entireties protection may become even greater if Michigan adopts a proposed bill that would give entireties creditor protection to assets that spouses retitle in their revocable grantor ‘joint trust.’
  3. Retirement Assets: Individuals who have most of their wealth held in IRAs or qualified plans, as those assets are protected by federal and state statutes from creditor claims. MCL 600.6023 and IRC 401(a) (13) and ERISA 206(d).
  4. Life Insurance and Annuities: Often clients will have a large amount of their wealth held in life insurance cash surrender value policies or annuities. In general, many of these policies will be protected from creditor claims by virtue of a Michigan protective statute. MCL 500.2207.
  5. LLCs: If a client has considerable wealth held in a limited liability company with other LLC members, then a creditor will probably be very cautious before an attempt is made to levy and execute on the client’s LLC membership interest due to Michigan’s statute which gives to the judgment creditor only a charging order against the member’s LLC units, i.e. the judgment creditor could not vote the debtor’s membership interests to liquidate the LLC nor vote to force a distribution to members. MCL 450.4507(4).

Likely Candidates for an APT:

  1. Physicians
  2. CEO’s (or those who must regularly sign financial statements on behalf of their businesses)
  3. Professional Athletes
  4. Celebrities
  5. Aircraft Pilots
  6. Individuals contemplating marriage (The question being whether a prenuptial agreement is even enforceable in Michigan these days in light of the recent Allard decision, Michigan Court of Appeals, No. 308194 January 31, 2017.)
  7. Real Estate Developers? An APT may not be a reliable strategy for real estate developers who always seem to be leveraged in their business affairs. Real estate values are always hard to determine, as are the entities that developers often use to hold title to their real estate projects. Consequently, it may be difficult to accurately document and confirm values in the developer’s qualified solvency affidavit.

Trusts Possibly Established as an APT (MCL 700.1044(2):

  1. Qualified Personal Residence Trust (QPRT)
  2. Charitable Remainder Trust (CRAT/CRUT)
  3. Grantor Retained Annuity Trust (GRAT)
  4. Intentionally Defective Grantor Trust (IDGT)

Federal Bankruptcy and IRS Claims:

  1. Bankruptcy- 10 Year Look-Back Period: Federal bankruptcy law uses a ten (10) year look back period that enables the bankruptcy trustee to challenge a transfer of assets to an APT, despite Michigan’s 2 year statute of limitations period in which to challenge a distribution to the APT. There is a good chance that a Michigan APT will not survive a transfer challenged in federal bankruptcy court because: (i) the litigation takes place in federal court not a Michigan probate court, which otherwise has exclusive jurisdiction to determine if a transfer is qualified; (ii) the bankruptcy court follows its own statute and does not have to abide by state law; and (iii) federal case law precedent favors the bankruptcy trustees who challenge APTs, in contrast to more favorable state law court decisions that have dealt with APTs. However, it takes three (3) creditors to force a transferor into bankruptcy, so there may not be enough creditors to challenge the transferor’s APT in a bankruptcy setting.
  2. As a generalization, the IRS tends to ignore the limitations imposed by state property laws when it comes to levying and attaching a taxpayer’s assets in order to force the payment of back taxes. In US v Craft (2002) the Supreme Court ignored Michigan’s entireties creditor protection to attach one spouse’s interest in a tenants-by-the-entireties owned asset to satisfy one spouse’s unpaid income tax liability. The IRS always seems to ‘win’ when it comes to collecting back taxes.

State APT Comparisons

  1. Nevada: Nevada has the most aggressive APT statute, with no exception creditors A recent Nevada appeals court decision confirmed just how protective its legislation is when spouses, each with their own Nevada APT, found themselves in a divorce court: the court took a hands-off approach to both APTs when dividing the marital estate. See Klaback v. Nelson, 133 Nev. Advance Opinion, May 25, 2017).
  2. Other States: Alaska, Delaware, Hawaii, South Dakota and Missouri all have APT statutes but each differs greatly in its terms, e.g. solvency affidavits, exception creditors, look-back periods.
  3. Michigan’s Model: Michigan’s statute was principally modeled after the Ohio and Tennessee APT statutes, but Michigan added a few enhancements to its APT version.

Practical Observations on the APT’s Purpose and Use:

  1. Not Everyone Needs an APT: Not all clients will be good candidates to adopt an APT. Wealth that is held as tenants-by-the-entireties is generally protected (other than when dealing with the IRS), as are most retirement assets. Consequently, an APT should only be considered when: (i) there exists a realistic exposure to creditor claims, not imagined claims that an attorney might conjure; and (ii) substantial assets exist that are not protected by some other statute, e.g. a large investment portfolio held in the client’s name alone.
  2. Limit the Retained Rights in the APT: It would be a mistake to include in an APT all of the rights that Michigan’s Act permits a transferor to retain in their APT. The fewer the rights retained, the more likely the APT and its purpose will be respected by a court. The old adage that pigs get fat, hogs get slaughtered still applies even with APTs.
  3. Use a Professional Trustee: Michigan’s APT statute requires the use of a Michigan trustee. That trustee can be an individual who resides in Michigan and maintains custody of assets in Michigan. The danger of using an individual trustee (e.g. a close family member; friend; someone related or subordinate to the transferor) and not a professional trustee is that an individual trustee may be less inclined to follow all of the technical rules imposed by the Michigan APT statute, e.g. not demand a new Qualified Affidavit of Solvency each time an asset is transferred to the APT, or an individual trustee may be more likely to overlook the APT’s distribution restrictions, thus giving a court reason to ignore the APT completely if its terms are not respected.
  4. Limited Funding of the APT: Not all of the transferor’s money or assets should be transferred to the APT, to avoid an implied understanding that the APT trustee will always make trust assets available to meet the transferor’s daily living expenses. Perhaps one-third of the transferor’s liquid wealth can be safely transferred to the APT. Enough wealth should be retrained outside of the APT for the transferor’s daily living expenses to avoid a presumption that there exists an implied agreement between the transferor and the trustee that the APT assets will readily become available to meet the transferor’s daily living expenses – in effect ignoring the restrictive terms of the trust.
  5. Use A Double-Layer Wrapper: If an investment portfolio is considered to be the client’s most at-risk asset, consider ‘wrapping’ the investment portfolio in an LLC, and then transfer the LLC membership interest to the APT. If the APT is successfully challenged by a creditor, then the asset that will be distributed to transferor, and at most the successful creditor will be only be able to obtain a charging order against the LLC membership interests. That then leaves the APT trustee in charge as the LLC’s manager with the discretion to make distributions, or not, and the creditor with no voting rights cannot force a distribution from the LLC.
  6. No Implied Agreements: No implied agreement should exist between the transferor and the trustee that the transferor will receive a distribution whenever one is requested from the APT. Nor should the APT either be viewed, or treated, by the transferor as a bank or lending arm of the transferor’s family.
  7. Maintain Insurance Policies: Adopting an APT is not an excuse to drop professional, casualty, auto, homeowners, or umbrella insurance policies. Insurance is still needed to cover predictable every-day claims.
  8. Change Spendthrift Clauses: Most trust instruments that contain a spendthrift clause will probably have to be revised for the trust to be compliant with Michigan’s APT legislation. Consider decanting an existing irrevocable trust to adapt its spendthrift clause to what the Act requires to obtain the protection of the Act for trust beneficiaries.
  9. Longer Record Retention: Because an APT can be attacked several years down the road, e.g. the Bankruptcy Court’s 10 year look back period, it is imperative to obtain and retain for at least five to seven years of the transferor’s 1040 income tax returns, actual investment account statements, qualified appraisals of closely held businesses and real estate, and a comprehensive personal financial statement. All of these documents will be necessary to prove that the transferor’s sworn representations in his/her Qualified Affidavit of Solvency were accurate at the time the assets were transferred to the APT. Do not rely on the transferor to retain these important records.
  10. Build a Trust Narrative: There should be a strong narrative that accompanies the creation of an APT, perhaps expressed in a material purpose clause as part of the APT. For example, the trust’s material purpose provision might describe the transferor’s concerns over a beneficiary’s spendthrift tendencies, which provides an explanation why the APT was created, and thus which explains that the transferor’s motivation was to not delay, hinder or defraud his creditors but was to protect other trust beneficiaries from themselves, which is an entirely legitimate purpose.
  11. Prenuptial Agreement Surrogate: It may be that an APT will be more useful than a prenuptial agreement in light of recent challenges to the enforcement of prenuptial agreements by Michigan courts. Even if the spouses are married, one spouse can create and fund an APT but their spouse must consent to the transfer and acknowledge the consequences of the APT holding title to the transferor’s assets. It will be interesting to see how Michigan divorce courts respond to the very clear APT statute directive that a divorce court can neither divide the APT, nor can the judge take into consideration, directly or indirectly, the assets held in the APT that benefits only one spouse (asset division or setting a spousal support award.)
  12. Giving Up Control: A client who seriously considers the adoption of an APT needs to be fully aware that he/she is giving up control over the assets to be transferred to the APT, and that the trust is not something that they can easily unwind or conveniently ignore when it serves their purposes.

Conclusion: Michigan’s APT statute was adopted to attract trust business. An honest reading of the statute is that it is intentionally designed to make it difficult for creditors to attack transfers to an APT. The creditor must come to Michigan to file their claim. The creditor must litigate their claim before Michigan probate judges who, hopefully, will be familiar with the statute. Creditors will normally face a short two year statute of limitations, with few exceptions. Creditors will face a very high clear and convincing burden of proof standard. Creditors will have to prove that they were intentionally defrauded by the transferor if their claim arose after the transfer to the APT (not just show that another creditor was able to meet the high burden of proof.) In short, the purpose of Michigan’s APT statute is not necessarily to make the APT bullet-proof to all creditor claims, but to frustrate a creditor to such an extent that the creditor will be much more likely to negotiate a settlement of their claim against the transferor for pennies on the dollar. Whether that is good public policy or bad public policy ultimately is in the eyes of the beholder. Currently it is Michigan’s law.