 | Gary D. Halbert President & CEO |
Offshore Trusts
Warnings From 1996 Come Home To Roost
In late 1994 and 1995 investor interest in offshore trusts and offshore investing boomed. This was in no small measure due to Clinton's massive tax increase which currently has income tax rates at 36% for Americans earning over $161,000 and 39.6% for those earning over $288,000 a year. As always, people in these tax brackets looked for ways to avoid or defer the higher taxes. Meanwhile, interest in "asset protection" soared, partly due to the perception that Clinton was in the back pocket of the trial lawyers. Whatever the reasons, investors were eager to find ways to reduce taxes and obtain more protection for their assets. Investing outside the US seemed especially alluring to many.
Whenever a desire such as this develops, there is no shortage of outfits that spring up to offer investors what they think they want. In 1994 and 1995 numerous groups burst onto the investment scene with splashy pitches for offshore trusts that were touted to offer "tax free" investing, "bulletproof" asset protection and "ultimate" privacy. In only months, these groups dominated the largest investment conferences in America. As a speaker at some of these conferences, I saw these gaudy offshore promotions first-hand. I knew the promises - "tax free" investing, "bulletproof" asset protection and "ultimate" privacy - couldn't be true, especially not at the (initial) low prices the promoters were quoting for a "turn-key" offshore trust. Yet investors were lined up at these seminars, eagerly forking over their money.
Meanwhile, many of our own clients were receiving flashy mail packages touting these cheap offshore trusts. Not wanting our clients to fall into these traps, I spent over six months consulting with tax experts and professionals who were extremely knowledgeable and experienced in the area of offshore trusts and asset protection. They helped me understand all the issues, dig through the hype and find the many, sometimes dangerous, flaws in the (initially) cheap offshore trust promotions. After months of research, I devoted the April and May 1996 issues of Forecasts & Trends to a Special Report on the problems and pitfalls with offshore trusts as they were being promoted. Many of you may remember those Special Reports. My overall conclusion was that these products would end-up getting a whole lot of people in a whole lot of trouble!
IRS Cracks Down On Offshore Trusts
Over the last year the IRS has begun a serious attack on offshore trusts. If you read the Wall Street Journal regularly, you have no doubt noticed the increasing reports and stories about the IRS coming down on Americans with offshore trusts. This is hardly a surprise, especially given how many Americans have set up these trusts in recent years, and have been (unknowingly in many cases) breaking the law by not reporting their offshore gains and paying taxes on them. This is sad because many of these investors were led to believe that they would not have to report or pay taxes on gains in their offshore trusts. Now many are getting hammered by the IRS, just as I warned in 1996.
Given the IRS crackdown that is underway, and given the importance of this issue, I want to revisit the highlights of those 1996 Special Reports once again. As I told you back then, offshore trusts - if structured AND maintained properly - make sense for some investors, particularly very high net worth people and/or those with a high risk of being sued. But doing it right is not cheap and it is not easy. On the other hand, most of us can achieve a meaningful amount of tax deferral and substantial asset protection by using domestic trusts, without the hassles and high costs of offshore trusts, and without making ourselves prime targets of the IRS.
As you read on, keep in mind that my findings and conclusions about offshore trusts were the result of hundreds of hours of research and consulting with some of the best experts in this field. Some of you may also remember that I made a lot of people very angry when I published those Special Reports in 1996, in particular some of the very promoters of (initially) cheap offshore trusts! Yet most of my 1996 warnings have now come home to roost, hopefully not for any of our clients. Read on as I revisit this important issue.
Not For Everyone
As noted on the previous page, well structured offshore trusts can be a very good tool for very high net worth individuals, especially those in a profession with a high risk of being sued (malpractice, etc.). However, in order to organize and maintain a legitimate offshore trust, you need to be prepared to spend some serious money to have experienced professionals on your team. The tax laws are continually changing, both in the US and in the foreign jurisdictions. If your trust isn't continually updated and meticulously restructured to satisfy the changing regulatory environment, you're asking for big trouble (the word jail comes to mind)! To accomplish this, you are looking at both some serious time and money on the front end, and significant expenses each year to maintain a sound offshore trust.
The experts I consulted with, who have structured offshore trusts for wealthy investors for years, told me that unless you have several million dollars to move offshore and/or a high probability of being sued, you probably don't want to consider an offshore trust. Very high net worth people with multiple millions to move offshore will typically spend a minimum of $5,000-$10,000, and often $10,000-$20,000, initially to set up an offshore trust. And they will spend more each year thereafter to administer the trust and keep it current. The paperwork and documentation is daunting to say the least. Additionally, all of this must be done very, very privately. Here's what I said in 1996, and it is still true today:
"The problem is that setting up an offshore trust that can withstand attack by creditors, bloodthirsty attorneys and the government is both complex and difficult. And if done right, expensive."
Cheap Offshore Trusts Are Often A Ripoff & Can Easily Land You In Jail!
Despite the recent IRS crackdown on offshore trusts, many of the groups promoting cheap, even so-called "do-it-yourself" trusts, are still out there. Some of these groups will sell you a package for (initially) as little as $100 to $500. I keep emphasizing the word "initially" because every one of these deals I have seen contains a plethora of additional (and sometimes hidden) costs beyond the cheap introductory price. And all too often, the subsequent (and often hidden) costs for administration, legal fees and asset and investment management are greatly overpriced. If that weren't bad enough, the offshore investment options are often very limited and sub-standard in my opinion. Yet the hidden, overpriced costs and poor investment options are not the worst part.
The worst part is that these (initially) cheap offshore trust deals can be extremely misleading when it comes to guiding you through the maze of structural choices, jurisdictional choices, regulations and legalities. At every step of the way, you can make seemingly unimportant choices that can render your offshore trust worthless in terms of asset protection, or worse, land you in jail (or at least heavy fines) for tax evasion. Ironically, some of the groups promoting these offshore trusts do include most of the critical legal and tax requirements in their materials. Unfortunately, this absolutely critical information is often buried in the "fine print" because it would turn-off/scare-off many potential purchasers. Again, here's what I warned in these pages in 1996:
"Unfortunately, I believe these investors are buying just enough information to get themselves into trouble, plus I don't believe they will accomplish nearly the level of asset protection they think they are getting." These words are unfortunately coming true in spades for many Americans who thought they were "bulletproof" when they bought one of these cheap offshore trusts packages in recent years, and it's only going to get worse. I'll come back to this issue later.
The Structure Of Offshore Trusts
An offshore trust is typically structured as a foreign corporation in one of many offshore jurisdictions. Typically, the offshore jurisdictions of choice are countries (often referred to as "tax havens") that will not cooperate with US authorities or plaintiffs' attorneys who are seeking to seize the assets in the trust. While there are many tax haven countries around the world, they are increasingly succumbing to US and international pressures to cooperate with tax authorities.
The primary players in an offshore trust are the Grantor, the Trustee, the Beneficiaries and the Protector. The Grantor is the person or entity which establishes the trust and transfers assets into it. The Grantor names the Beneficiaries which are usually itself and/or its heirs. The Trustee is an individual or an institution that manages the trust, carries out its investment policies and distributes money to the Beneficiaries. The Protector is normally a third party appointed by the Grantor to oversee the Trustee - with the power to replace the Trustee if the Grantor decides that the Trustee is not acting according to the instructions or in the best interest of the trust or the Beneficiaries. There is also a foreign administrator and foreign attorneys involved in this process. Sounds complicated already, doesn't it?
Obviously, the Trustee and the Protector are the critical participants and typically, these are foreign persons or entities you engage on your behalf. Since the Trustee will be the person or company who is caring for your trust, overseeing the trust's assets and carrying out your wishes, it is obvious this needs to be a person or entity in which you have enormous trust. Likewise, the Protector must be someone in which you have equal or even more trust, since the Protector can usually fire the Trustee and replace him at its discretion.
For many people, this is where their interest in an offshore trust stops. Most people do not know anyone outside the US that they would entrust the control, care and management of their assets as Trustee. Even fewer know a second foreign person or entity that they would trust to serve as the Protector, with power to fire and replace the Trustee. However, the groups promoting offshore trusts have relationships in place with foreign companies that will provide these services. Investors who buy these offshore trust deals have to trust the promoters to refer them to reliable(??) parties outside the US to serve as Trustee and/or Protector for their assets. You wouldn't think most people would trust their assets to foreigners they've never met, but thousands have done so in recent years.
The Grantor Should Not Be The Protector
As noted above, the problem of finding both a foreign Trustee and a foreign Protector stops many investors in their tracks. Many people cannot (nor should they in most cases) make that leap of faith. However, some of the groups promoting these offshore trust deals recognized this roadblock ahead of time, and in some cases they encourage the Grantor (the person setting up the trust) to also be the Protector. While there is nothing illegal about being both the Grantor and Protector of an offshore trust, this is usually a BIG mistake in terms of asset protection.
One of the key elements in a good offshore trust is the ability to demonstrate (in an IRS audit, or in court if necessary) that the Grantor does not have control of the assets in the trust. Therefore, such trusts are usually organized so that the Trustee has legal control of the assets, not the Grantor. While there are almost always informal agreements that the Trustee will comply with the Grantor's wishes and instructions (typically conveyed verbally, not in writing), the Trustee should have legal control of the assets. This way, the Grantor can demonstrate (or attempt to) in a court proceeding or IRS investigation that he/she/it does not have control of the assets, and therefore cannot force the trust to give them up. If structured and maintained correctly, this arrangement can be very effective in withstanding attacks by plaintiffs' attorneys or the IRS.
On the other hand, if the Grantor and the Protector are the same person (or entity), most of the asset protection is blown. Remember, the Protector normally has the power to fire and replace the Trustee. If the Grantor is also the Protector, then the Grantor has ultimate legal control over the assets. Attorneys, the courts and the IRS typically pounce on this arrangement. Unfortunately, some of the promoters of cheap offshore trust deals don't make this potentially fatal flaw absolutely clear to the purchasers.
Attacks On Offshore Trusts: To Declare, Or Not Declare, Those Assets?
If someone or some entity is mounting a serious effort to separate you from your assets, it will almost always be through a court action, or directly in the case of the IRS. The IRS does not have to proceed through the courts to seize assets; it can invoke its own levies, liens, etc. and even put people in jail, virtually at-will.
If a judgement is rendered against you, the court will typically issue a a "Writ of Mandamus" which orders you to declare all your assets (or at least enough to settle the judgement) whether those assets are in the US or elsewhere. If you refuse to produce such a list, you may be fined or jailed for contempt of court. If you knowingly produce a list of assets which is incomplete, you may be jailed for perjury. Any plaintiff's attorney with half a brain will ask you under oath, "Are you the Grantor or Beneficiary of any trust in the US or outside the US?" If the judge requires you to answer, and you are such a Grantor or Beneficiary, you must answer YES, or perjure yourself. The point is, you can go to jail for failing to report assets to a court or the IRS. Given the choice - report or go to jail - I believe most people will report!
Some who promote these offshore trusts take the position that if you have assets in an offshore trust, you do not have to admit the existence of your trust or declare those assets to a court or the IRS. And many people apparently believe them. As noted earlier, I have consulted with numerous experts on this question, and they assure me that if you are asked the question above directly, you would have to declare such offshore assets, if you are the Grantor or if you or your heirs are the Beneficiaries - unless you are willing to commit perjury and risk going to jail.
No doubt some of you reading this just got a serious shock from the preceding two paragraphs! Especially those of you who have such offshore trusts already. Likewise, I know that some in the business of selling these trusts or organizing them will read this and strongly disagree and stand staunchly by their opinion that you don't have to report these offshore trusts and the assets in them. What I am telling you is I believe they are wrong, and so do the experts I have consulted with! Remember, you can go to jail for this.
Even more proof can be found by simply looking at Schedule B of the IRS's 1040 tax return form. This form asks two questions regarding foreign income, one of which asks specifically if you are a Grantor of a foreign trust. If you answer YES, then you have to file additional forms to report any income from the trust and pay taxes on it. In this case, there is no question regarding whether you have to report. It's the law.
In the case of the courts, as mentioned above, it is routine for a judge and/or a plaintiff's attorney to ask the defendant, point-blank (yes-or-no) under oath, "Are you the Grantor or Beneficiary of any trust in the US or outside the US?" And the judge has the power to force the defendant to answer or risk contempt of court. This is not rocket science!
As I will discuss later, there are ways to organize your offshore trust so that, even if you answer yes to the question of being a Grantor or Beneficiary of the trust, you may convince the judge that you don't have to declare the assets in the trust. Unfortunately, many of the offshore trusts promoted in recent years were not organized with such protections.
How "Bulletproof" Can You Be?
Given these facts, and the possibility that you might have to choose between declaring such offshore assets or risk going to jail, I think this puts a whole new light on how to organize an offshore trust, as well as who should do so. To further understand this, let's follow the process through even further. If a court renders a judgement against you, and you must declare your assets, the plaintiff(s) and its attorney(s) will receive the list of those assets including your offshore trust. The plaintiff's attorneys will then attempt to gain control of those assets by notifying the holders (banks, brokerage firms, custodians, mortgage companies, etc.).
If the plaintiff is not satisfied with the domestic assets it can go after relatively easily, it may also go after the assets held in the offshore trust. In this case, the attorneys investigate the laws of the country in which the trust is domiciled to see if that jurisdiction will cooperate and force repatriation. Most tax haven jurisdictions (including the Bahamas and Cayman Islands) will simply ignore creditors and refuse to cooperate. In that case, and if the plaintiff is really serious (ie - lots of assets in the trust), the attorneys file a lawsuit in the foreign country. The suit must be brought in accordance with the laws of that country and are always costly. Again, such suits are only likely if the plaintiff believes there are substantial assets in the trust.
The previous two paragraphs deal only with creditors and/or individual plaintiffs. If the US government (IRS or any other agency) goes after your offshore trust, it is a much more serious matter. The laws of most foreign countries, including many of the tax havens, contain statutes that allow, under certain defined circumstances, penetration of private trusts, especially if it is the US government after your assets. Likewise, most foreign financial institutions (including Swiss banks) are not willing to incur the wrath of the IRS if it wants to get you badly enough. This is precisely why it is critically important to have your offshore trust structured in such a way that it may be able to withstand such attacks.
Documentation Is Critical
Let's continue with the example above and take it to the next step. The plaintiff's attorneys requested assistance from the foreign country where your trust is domiciled, but the government just ignored them - sorry, we can't help you. Depending on the jurisdiction, the attorneys are then likely to file a lawsuit in the courts of that country. By the way, all of this does not happen in a vacuum. Normally, you and your foreign Trustee will know what is happening as it occurs. The Trustee, if a good one, will monitor the progress of the court proceeding carefully. The main thing the plaintiff's lawyers try to prove is that you, as the Grantor or a Beneficiary, have control over the assets in the trust. If they can prove that you have control, directly or indirectly, they can usually penetrate the trust and get at the assets. As I will discuss below, the issue of control is critical in a well designed trust.
If they can't prove you have control, they will then try to determine that the trust is invalid. Specifically, they will examine every document, every piece of paper and anything they can get their hands on to see (among other things) if all required documents are in place and if each and every one was executed properly. If anything important is not there, or if documents were not executed flawlessly, or if the documents haven't been updated to reflect changes in the laws, the plaintiff can often prevail and penetrate the trust. Screw-up just one piece of paper, or fail to have it, and you can lose if someone is seriously after your assets. This is another critical reason why I would never recommend a cheap or do-it-yourself offshore trust to anyone!
Collapsing The Trust
A well designed offshore trust should be able to withstand such attacks by creditors and plaintiffs' attorneys, and in some cases, even the IRS. However, as a further protection, especially for those with large assets to protect, some offshore trusts are organized with provisions allowing the Trustee to collapse the trust, under certain conditions, and set-up a new trust in a new jurisdiction. If the Trustee sees that the plaintiffs are likely to be successful in the courts, he can (if properly authorized) dissolve the trust and move the assets to a new trust somewhere else. I am told that many plaintiffs who penetrate such trusts, only to find that the Trustee has (with authority) moved the assets to a new jurisdiction and a new trust, will give up at that point.
However, the decision to structure the trust such that the Trustee has the power to collapse and dissolve it, and move the assets to a new jurisdiction in a newly formed trust, is NOT one that should be made lightly. While it may be desirable in terms of asset protection, it does give far greater powers to the Trustee. Imagine giving some foreigner or offshore trust company the power to dissolve your trust and move your assets to some new jurisdiction! While some offshore trust companies and administrators are very old and very trustworthy, the decision to grant someone else this kind of blanket authority over your trust and your assets is a very serious decision - and one that most of us would not be comfortable with.
Revocable Vs. Non-Revocable Trusts & Discretionary Vs. Non-Discretionary Beneficiaries
As discussed above, if the plaintiff or the IRS can prove that you have control over the assets in the trust, directly or indirectly, they can usually penetrate the trust and get to the assets. Thus, it is crucial how you place such assets. When you place assets in a trust (foreign or domestic), you may do so either revocably or irrevocably. This, among other things, determines whether or not you actually "control" the assets. If the assets were given revocably, then the Grantor will always be deemed to be in control. Likewise as discussed earlier, the Grantor and the Protector should NOT be the same person. If the Grantor is also the Protector, that means the Grantor controls the Trustee (can replace him) and therefore, also controls the assets (albeit indirectly).
In many trusts, the Grantor is also the Beneficiary (or one of the beneficiaries). Another key to the control issue is whether you are a discretionary or non-discretionary beneficiary. If you are a non-discretionary beneficiary, the Trustee is required to give you money or assets (subject to certain provisions) periodically or upon demand from you - even if a court has ordered you to make the demand. However, as a discretionary beneficiary, the Trustee is not required to make any distribution upon your request. Some trusts are organized such that the Trustee expressly will not distribute assets to the discretionary beneficiaries if the Trustee believes the beneficiaries are acting under duress (ie - upon the order of a court or the IRS).
Organizing an offshore trust in which you are a discretionary beneficiary (no control) is not a decision that you should take lightly. However, from a strictly asset protection standpoint, it is important that you be a discretionary beneficiary. Let's say that in a court you must answer "yes" to the question, "Are you a Grantor or Beneficiary of any trust in the US or outside the US?". If you can document that you are a discretionary beneficiary, and therefore cannot force the Trustee to distribute the assets, some judges will not force you to declare the assets in the trust. This is especially likely if the trust documents make it clear that the Trustee is not going to distribute assets to you under duress (pressure from creditors, for example).
In light of the discussion above, the following recap is important if asset protection is the main purpose of your offshore trust:
1. The trust should be irrevocable, not revocable;
2. The Grantor should not be the Protector; and
3. The Beneficiaries should be discretionary beneficiaries, not non-discretionary beneficiaries.
If the courts or the IRS can determine that the Grantor controls the assets, either because the trust is revocable, or because the Grantor has also named himself as Protector, the asset protection element is blown - unless you are willing to commit perjury. Likewise, if the beneficiaries are non-discretionary, the trust can usually be penetrated.
Declare Or Not Declare -- That IS The Question
For over 20 years now, I have known clients who have offshore trusts. Some have gone to great lengths to set these trusts up very, very privately. Some have gone so far as to never even speak to their offshore Trustee on the phone, and only do so in person every year or so while on a "vacation" outside the US. Yet the question always lingers: do you have to disclose the existence of an offshore trust and/or declare the assets held within that trust? Unfortunately, many people who have offshore trusts believe the answer to this question is, NO. Sadly, I believe they are wrong.
Let's say you are in a court proceeding or an IRS investigation/audit, and the judge or IRS demands that you declare all of your assets. If you fail to declare all of your assets, you could end up in jail! Or, let's say you are asked the routine question noted above: "Are you a Grantor or Beneficiary of any trust in the US or outside the US?" If you answer NO to this question, when in fact you do have an offshore trust, you could also end up in jail! It's called perjury.
Unfortunately, some of the groups promoting offshore trusts tell people they do not have to disclose the existence of their foreign trust, nor do they have to declare the assets in such trusts in a court proceeding. Yet even if you have an irrevocable offshore trust in which you are not the Protector, and even if you are a discretionary beneficiary, you risk committing perjury if you fail to disclose the existence of your foreign trust, or any other trust for that matter.
Again, I know some of you will disagree with me on this, because it's not what you've been told. However, if you will consult with an experienced professional in this field, maybe even your CPA, I believe you will find that I am correct on this critical point.
A Final Thought To Consider
While some people choose to go the cheap route (and make lots of mistakes) and others spend more to use experienced professionals to set up a foreign trust, one of the common goals is to protect those offshore assets from any possible threat, including the IRS. As I've discussed above, there are some ways to increase the odds that your offshore trust will not be penetrated. These include (among other things) not being the Protector of the trust, allowing your Trustee to collapse the trust and move it and the assets to a new trust in a new jurisdiction, and being a discretionary beneficiary. In some cases, people organize their offshore trust with specific instructions that the foreign Trustee NOT distribute or repatriate any assets to the Grantor or the Beneficiaries in the case of duress - such as pressure or orders from a court or the IRS.
While all this sounds good, consider the following scenario. It is not impossible that a court or the IRS could levy heavy fines against you, or even throw you in jail, perhaps after finding you in contempt or guilty of perjury. If your offshore trust is structured as discussed above, it could very well be that you cannot get the Trustee to distribute money or assets to you to use in your defense or to settle a judgement - even if you try. If your trust is structured as outlined above, and if you've given the Trustee instructions not to distribute or repatriate assets in the case of duress, you may not be able to get a penny of your offshore assets no matter how dire your circumstances may be! I don't think most people who set up offshore trusts, especially those who go the cheap route, consider this possibility, but it can happen.
Conclusions
As you can see, offshore trusts are NOT for everyone, although you would never get that idea from the promotions you might see or hear. There are lots of potential problems and pitfalls you need to avoid. To set up an offshore trust correctly, you need experienced, professional assistance, both in the legal area and the tax area. Without it, you may have just enough information to get yourself in a lot of trouble! Organizing and maintaining an offshore trust is expensive, despite what you may read or hear from groups promoting (initially) cheap packages. Generally speaking, only those with a minimum of one million to several million dollars to move outside the US should consider an offshore trust.
In this issue, I have only focused on some of the structural and legal issues of offshore trusts. The tax issues are an entirely different, but equally complicated, matter. Here, too, there are many problems and pitfalls and misconceptions that can get you into a lot of trouble and/or land you in jail. Most importantly, those who claim that you can invest "tax-free" offshore are just plain wrong! Next month I will revisit some of the major tax issues and reporting issues required of offshore trusts. Hint: it's pretty ugly!
The bottom line is, offshore trusts - if structured AND maintained properly - make sense for some investors, particularly very high net worth people and/or those with a high risk of being sued. But doing it right is not cheap and it is not easy. On the other hand, most of us can achieve a meaningful amount of tax deferral and substantial asset protection by using domestic trusts, without the hassles and high costs of offshore trusts, and without making ourselves prime targets of the IRS. Next month I will conclude this discussion with the tax issues related to offshore trusts, as noted above, and specific ideas for how most people can obtain a significant amount of asset protection with the use of domestic trusts.
Finally, if you are simply looking for a way to diversify your investments offshore, or a way to hedge against a falling US dollar, there are plenty of ways to do so without having an offshore trust, and without making yourself a target of the IRS. Next month I will talk about some of these options, including our own offshore fund. In the meantime, if you are interested in investing offshore, call us at 800-348-3601 for more information.