01-08-2025
Offshore Trusts Offer Liability Protection But May Create More Tax
A lawsuit from a disgruntled employee of a successful family-owned business can bankrupt the family that built the business over generations. To prevent such unexpected ruin, a Foreign Asset Protection Trust (FAPT) can provide significant creditor protection, and even be implemented in conjunction with tax-efficient planning. However, FAPTs have a reputation for harboring hidden financial accounts and serving as tax evasion vehicles with tiered shell entities. Especially for founders and investors building wealth through investments in high-risk ventures and assets, FAPTs are an attractive option to mitigate liability exposure. In an increasingly global business world, especially for multinationals, FAPTs can be legal and effective vehicles to minimize exposure to frivolous lawsuits. However, the details of the structure and administration is key to its success and audit survival.
A FAPT must have substantial economic substance. Especially for risky businesses, including professions such as high-stakes lawyering and medicine, a FAPT would likely meet that requirement with a purpose being to prevent asset depletion due to frivolous litigation. However, a settlor retaining rights to the management and control of the FAPT would risk losing the liability protection. Oftentimes, FAPTs are created in debtor-friendly jurisdictions such as the Cook Islands, Nevis, Jersey, etc. A FAPT has to have a foreign third-party as trustee provide broad discretion and control to the trustee. Companies operating as third-party trustees for the FAPTs rely on their selection based on their decades of reputation in managing the trust assets, discreetly and legally. While many asset protection trust are drafted appropriately to meet these and the multitude of irrevocable trust requirements, FAPT failures can arise from issues involving access to distributions and the nature of the assets held in the trusts.
The essential structure relies on transferring the assets of the settlor subject to high-risk whether due to their business industry, investments, or marital situation to an offshore trust, the FAPT before the liability is contemplated. If the assets placed in the trust have a U.S. situs, while attachment may be protected due to the need to pursue the action in the offshore jurisdiction, it does not prevent the debtor from being forced to repatriate the asset and accordingly, pay the debt. Holding investments in an offshore financial institution, such as an account in Singapore, Liechtenstein, or the Cayman Islands may offer some additional protection and limit exposure. However, U.S. settlors and beneficiaries with interests in foreign trusts are subject to foreign trust reporting requirements including Forms 3520 and 3520-A in addition to foreign account reporting under FBAR and FinCen requirements. Most FAPTs are foreign grantor trusts with income flowing through to the settlor, which subject the trusts to foreign trust reporting.
Additionally, FAPTs require careful navigation of cross-border tax laws and U.S. foreign tax and trust reporting obligations, which may include Passive Foreign Investment Corporation and Controlled Foreign Corporation rules including GILTI tax and FATCA and FinCen reporting. If the FAPT owns interest in a foreign corporation, such as a company established in the offshore jurisdiction, and the FAPT has US beneficiaries, the shareholders, depending on how the FAPT is structured may be subject to GILTI tax, now renamed under the One Beautiful Big Bill Tax Act (OBBBA) to NCTI which taxes income regardless of repatriation by way of a dividend payment. However, a FAPT drafted primarily with creditor-protection in mind generally does not offer tax-protection and the exposure to more nuanced tax implications due to the structure of investments in a FAPT may be increased without simultaneous asset protection planning which considers tax-efficiency.
