The 10 Biggest Legal Mistakes Physicians Make When Using Offshore Trusts

Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)

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Executive Summary

Many physicians, due to lack of information or misinformation, do not take advantage of the full spectrum of asset protection legally available to them. As a result, rather than effectively protecting their assets from creditors, they leave their assets exposed and incur unnecessary expenses, legal and otherwise. Therefore, physicians should proceed with caution and use experienced counsel when considering how to best protect their assets or use offshore trusts.

Mistake 1 Not Getting Advice of Experienced U.S. Counsel

Physicians sometimes set up offshore trusts with the help of offshore companies or onshore persons that they believe will help them for bargain prices or because the physicians hope to achieve income tax savings. As a result, physicians may expose their assets to more liabilities than anticipated, and they may receive less protection from third-party claims than could otherwise be obtained. In addition, transferring assets to an offshore trust may have gift and estate tax ramifications. Although local counsel may be familiar with gift and estate tax issues, they may lack the knowledge and experience needed to optimize the protection afforded by offshore trust legislation. Obtaining competent legal counsel will result in greater protection of assets with less exposure to liabilities and headaches, as well as provide a workable estate plan.

Action Step Physicians should consult with experienced asset protection counsel before they execute, or start to title assets in the name of, offshore trusts.

Mistake 2 Making Erroneous Assumptions about What an Offshore Trust Entails

Physicians often recoil at the suggestion of offshore trust asset protection planning because they mistakenly assume that such planning entails the immediate loss of control over their assets. However, an offshore asset protection trust (OAPT) plan may be structured so that the liquid assets (e.g., cash, securities, and bonds) of the physician are held in a limited liability company (LLC) which, in turn, is wholly owned by the offshore trust (the trust with the LLC). If the physician is named manager of the LLC, the physician would retain day-to-day control over the assets. Only at the point that the physician faces a serious threat from a third party (the critical time) would the physician’s day-to-day control be terminated, and the determination of the critical time would always be by the physician.

Also, just as a physician may have financial accounts anywhere, so may the physician’s OAPT or his or her trust with the LLC. Only at the critical time would the accounts need to be totally offshore, in a financial institution with no U.S. branch. Even at the critical time, the physician would be able to have his or her chosen asset manager continue to manage the assets (i.e., direct the buying and selling of securities).

Action Step Before dismissing the idea of using an OAPT, a physician should discuss the physician’s concerns with an experienced professional who regularly deals with offshore trusts.

Mistake 3 Assuming That All Offshore Trust Documents Provide Equivalent Protection

All offshore trust documents are not created equal. Many offshore trust companies offer trust forms, and these are often used by U.S. lawyers who are not well versed in offshore asset protection planning. If the particular offshore legislation permits, these forms will provide protective provisions, such as a “flight clause” and a “duress clause”; however, such form language will fail to provide for the effective execution of the clauses. For example, most flight clauses provide that the trust may “move” to another jurisdiction, if appropriate, without providing a mechanism to be certain that the flight clause can be affected under all circumstances (e.g., even if an injunction has been issued). Also, most form “duress clauses” nullify the attempted exercise of any power unless exercised by the power holder of his or her own free will, again, without providing a mechanism by which the trustee can be certain that a power is being freely exercised. Usually it is only counsel with extensive experience in offshore trusts who have thought out and provided for all contingencies.

Some physicians have OAPTs drafted by non-U.S. lawyers or other professionals located in the offshore jurisdiction. Although they may address protective clause issues, they will uniformly fail to draft a trust document providing for the optimum legal tax and estate planning under U.S. laws. For example, they rarely provide for the marital deduction or credit shelter trusts, thus possibly resulting in gift taxes and higher than necessary estate taxes.

Action Step Physicians should consult with U.S. counsel knowledgeable about offshore trusts, and if counsel doesn’t satisfactorily address all of their concerns, go elsewhere for counsel.

Mistake 4 Assuming That All Offshore Trust Jurisdictions and All Trust Companies Are Equivalent

Physicians often choose their offshore jurisdiction based on “curb appeal,” which is the most enticing place to visit (e.g., Bermuda, the Bahamas, or the Cayman Islands). This selection process is akin to a layperson picking a medical specialist based on the specialist’s proximity to a five-star restaurant. Those knowledgeable in the field of offshore asset protection have ascertained the best jurisdictions for registering a trust based on the following factors: the jurisdiction’s legal system (common law, rather than civil law), its enacted protective legislation applicable to offshore trusts (i.e., statutes of limitation, burdens of proof, consequences of fraudulent transfers, all of which vary significantly among the jurisdictions), its economic health and political/social stability, its primary language (English), and most important, its track record in applying its protective legislation to the trusts that have been attacked by creditors. Physicians often fail to realize that some offshore jurisdictions have legislation that provides less protection than that afforded by the physician’s home state. For example, the statute of limitations for attacking trusts is longer in the Cayman Islands than the four years applicable in most states.

In choosing a trust company, a physician should depend on counsel experienced with entities in the offshore jurisdiction, since all trust companies do not provide equivalent service. A physician should compare not only fees, but also ease of communication, expertise of staff, and track record in defending trusts.

Action Step Physicians should ask counsel how the proposed offshore jurisdiction and offshore trust company compares with others, and if counsel isn’t knowledgeable, go elsewhere for counsel.

Mistake 5 Making the Physician or the Physician’s Spouse a Trustee or a Protector

In the usual OAPT, there will be a trust protector (provided the applicable legislation allows one). Regarding the OAPT, the protector is the most powerful role in that the protector may veto any discretionary act of the trustee and remove and replace any trustee with or without cause. The initial protector is often a friend, a relative, or a company chosen by the physician settlor, but should never be the physician settlor or the physician settlor’s spouse. Also, a properly drafted OAPT will preclude the settlor and the settlor’s spouse from being trustees. A beneficiary should also be precluded from acting as a sole trustee and from participating in the exercise of any discretionary powers that might inure to the beneficiary’s benefit. Otherwise, a U.S. court could order the use of those powers so as to allow the creditors of the physician settlor, the physician settlor’s spouse, or other beneficiary to reach the trust assets.

Action Step A physician should ascertain that the trust document itself prohibits the physician or the physician’s spouse from being a protector or a trustee, and prohibits a beneficiary from being the sole trustee.

Mistake 6 Failing to Transfer or Receive OAPT Assets Properly

Physicians often execute OAPT documents, but fail to take the important step of funding the structure with assets. As soon as the trust (and holding entity) documents have been executed and filed, assets should be retitled in the name of the trust (or holding entities). Each transfer, initial and subsequent, to a trust (domestic or offshore) is subject to fraudulent transfer and solvency scrutiny. If a physician makes transfers after a claim has been made, that transfer may not have the ultimate protection, since the creditor will have a basis to attack the transfer. In addition, an asset loses the protection afforded by the trust and its jurisdiction once it is distributed to any beneficiary outside of the OAPT structure. However, the trustee in a properly drafted offshore trust structure will have discretion as to the manner of the distribution, and should be able to, among other things: directly pay expenses of a beneficiary, including the physician; permit the beneficiary, including the physician, to reside in a dwelling or other improved real estate owned by the OAPT (see Mistake 8); accumulate income; and/or purchase an asset exempt under the laws of the recipient beneficiary’s state, and then transfer that exempt asset to that beneficiary.

Action Step The physician should transfer eligible assets into the OAPT structure as soon as it is effective, and not have significant assets distributed without discussion with counsel. Such discussion should include a thorough review of any pending or threatened litigation or judgments.

Mistake 7 Failing to Understand How Distributions/Benefits Can Be Received

The purpose of an OAPT is to enable a physician to be able to enjoy assets without the assets being vulnerable to creditor seizure. A properly drafted OAPT should give the trustee(s) the discretion to make distributions of income and/or principal to or for the benefit of its beneficiaries, which would normally include the physician. However, just as having the most effective medication in one’s possession is useless without the knowledge of how to properly administer it, a well-structured asset protection plan is less than optimally effective if the physician is not clear as to how it works. The physician should understand whether and to what extent assets can be distributed, both when there is no claim against the physician, and most important, when there is a serious claim or judgment against the physician.

Action Step Before executing and funding an OAPT, a physician should be sure to understand how it operates, and if counsel cannot adequately and clearly explain its operation, the physician should go elsewhere for counsel.

Mistake 8 Assuming That Transfer of an Immovable Asset’s Title to an OAPT Will Provide Protection

Physicians may be told that transferring title of their assets to OAPTs will protect the assets from malpractice claims. This protection is true if the asset itself can be moved offshore by the trustee at the critical time, so that no U.S. court will have jurisdiction over it. However, certain assets, such as equipment, real estate (including a home or office building), and accounts receivable (“immovable assets”) cannot be moved offshore. Therefore, if a physician titles his or her immovable assets in the name of an OAPT and is sued, the fact that the immovable asset is still located in the United States makes it vulnerable to the claims of the physician’s creditor. For example, a court may disregard the transfer, especially if there is a fraudulent transfer issue, and have the property re deeded or retitled in the name of the creditor. The only way to make an immovable asset unattractive to a creditor is to remove its value. Removing value, by a mortgage or lien, and placing that value (proceeds of the mortgage or loan) into the OAPT in effect protects the immovable asset from the claims of creditors.

Action Step Physicians should consult with experienced counsel before they start to transfer title to a trust. They should also inquire about removing value from immovable assets, such as equipment, real estate, and accounts receivable.

Mistake 9 Purchasing Annuities or Life Insurance Contracts Instead of Implementing an OAPT with a Loan Structure

Physicians often borrow against their immovable assets to purchase annuity or life insurance contracts, believing they are taking advantage of their state’s limited exemption from creditors applicable to annuity or life insurance contracts. In most cases, the contract is distributed to the owners of the business (i.e., medical practice) as “nontaxable” deferred compensation (nontaxable because the continued ownership of the contract by the business owner is allegedly subject to a “substantial risk of forfeiture” if the owner leaves the business or loses his or her professional license). Such contracts are risky from two perspectives: First, it is almost certain that the “tax-free” distribution of the contract will not be tax free (because the Internal Revenue Service will not respect the contrived “risk of forfeiture” for a closely held business) and the ultimate protection depends on a U.S. court upholding the referenced exemption (which can and has been successfully attacked several times). Second, the interest paid on the loan incurred to purchase life insurance or annuity contracts will not be deductible (adding to the cost of the plan). Alternatively, a closely held medical practice can accomplish asset protection for its immovable assets by forming its own OAPT, and implementing a loan structure similar to the one described in Mistake 8.

Action Plan Medical practices should compare the benefits of an OAPT with a loan structure to the benefits of purchasing annuity or life insurance contracts.

Mistake 10 Assuming That OAPTs Provide Income, Gift, or Estate Tax Advantages

Contrary to what promoters often tout to U.S. citizens or residents, OAPTs cannot legitimately result in:

A reduction or elimination of income subject to tax;
Deductions for personal expenses paid by the trust;
Depreciation deductions for a physician owner’s personal residence and furnishings;
A stepped-up basis for property transferred to the trust;
The reduction or elimination of self-employment taxes; or
The reduction or elimination of gift and estate taxes.

Benefits like these are inconsistent with the tax rules applicable to trusts and the other entities that may be involved. The IRS has targeted these schemes, and attempts to avoid income tax may subject the physician taxpayer to civil or criminal penalties, or both.

Schemes often consist of convoluted, multitiered structures, typically involving more than one trust (and other entities as well), each holding different assets of the physician taxpayer (e.g., the business can be owned by one entity, the business equipment by a second entity, a home by a third, and an automobile by a fourth), as well as interests in other trusts. Funds may flow from one trust to another trust by way of rental agreements, fees for services, purchase and sale agreements, and distributions. Some trusts purport to involve charitable purposes. A common factor in each of these trusts is that the original owner of the assets that are nominally subject to the trust effectively retains authority to cause the financial benefits of the trust to be directly or indirectly returned or made available to the owner. For example, the trustee may be the promoter or a relative or friend of the owner who simply carries out the directions of the owner whether or not permitted by the terms of the trust. Often, the trustee gives the owner checks that are presigned by the trustee, checks that are accompanied by a rubber stamp of the trustee’s signature, or a credit card or a debit card with the intention of permitting the owner to obtain cash from the trust or otherwise to use the assets of the trust for the owner’s benefit. Promoters often advise potential physician clients not to contact their own tax attorney or accountant because the formal education undertaken by those professionals will somehow preclude their understanding of the scheme. These schemes may be known by a variety of names, including the common law trust, the pure trust, the pure equity contract trust, and the contract trust.

An OAPT is gift- and estate-tax neutral. Similar to conventional estate planning, using a properly drafted domestic inter vivos trust, the OAPT will, upon the physician’s death, avoid probate and the associated expenditure of money and time, thus offering similar advantages regarding the administration and distribution of the physician’s estate. Additionally, the OAPT structure limits the exposure to contests by beneficiaries and heirs-at-law, since it is not bound by state laws regarding the rights of spouses, children, and other heirs-at-law. Therefore, assuming that the OAPT is governed by a jurisdiction that does not recognize forced heirship rights (which typically refers to the civil law rules in Latin American countries that are similar to U.S. elective share rules), the physician’s wishes will govern distributions at his or her death.

At the physician’s death, the value of the assets in the OAPT will be included in the physician’s gross estate (unless there was a completed gift or sale to the trust). In order to take full advantage of all the estate planning techniques available, the OAPT should contain the provisions that otherwise would be found in the physician’s will or domestic inter vivos trust covering the unified credit, the marital deduction, and the generation-skipping transfer tax exemption.

Action Step Physicians should not use OAPTs to avoid paying income taxes, but they should be sure that the optimum gift and estate planning has been accomplished.

Conclusion

Physicians seeking to protect their assets who are mindful of these mistakes and take steps to avoid them will be most likely to achieve the desired protection for their assets.

Additional Resources

www.ProtectYou.com (a website authored and maintained by the law firm of Donlevy-Rosen & Rosen PA, Coral Gables (Miami), Fla.)
P. Donlevy-Rosen, “Protecting U.S. Client Assets With Offshore Annuities and Trusts,” Private Wealth Advisor, Vol. 2, No. 8 (Campden Publishing Ltd. April 2000); http://protectyou.com/pwa-04-00.html
P. Donlevy-Rosen, “Review of Offshore Jurisdictions–Jurisdiction 4: Bahamas,” Asset Protection News, Vol. 6, No. 3 (Aug. 1997); http://protectyou.com/apn6-3.html
P. Donlevy-Rosen, “Review of Offshore Jurisdictions–Jurisdiction 3: Barbados,” Asset Protection News, Vol. 6, No. 1 (March 1997); http://protectyou.com/apn6-1.html
P. Donlevy-Rosen, “Review of Offshore Jurisdictions–Jurisdiction 2: Anguilla,” Asset Protection News, Vol. 5, No. 2 (July/Aug. 1996); http://protectyou.com/apn5-2.html
P. Donlevy-Rosen, “Review of Offshore Jurisdictions–Jurisdiction 1: The Cook Islands,” Asset Protection News, Vol. 5, No.1 (Jan./Feb. 1996); http://protectyou.com/apn_v01.html
P. Donlevy-Rosen, Tax Advisors Planning Title 32: Asset Protection Planning (available only to RIA subscribers).
H. Rosen, “Offshore Trusts Safest Way to Protect Fixed Assets,” Florida Medical Business, Vol. 16, No. 3 (Feb. 4 – 17, 2003); http://www.protectyou.com/FlaMedBus02-03Art.pfd
H. Rosen, “Saving Estate Taxes in the U.S. Through Offshore Trusts,” Private Wealth Advisor, Vol. 3, No. 4 (Campden Publishing Ltd., Nov. 2000); http://protectyou.com/pwa-11-00.html