Differences between a Foreign Trust and a Domestic Trust

There are many different types of trusts, each with their own unique structure and uses. The primary distinction is between irrevocable (trusts where the terms are fixed and cannot be altered or terminated by the settlor after creation) and revocable trusts (trusts where the settlor retains a greater level of control and can therefore alter the terms of the trust at any point after its inception). 

Another common way to categorise trusts is according to whether they are based onshore (domestic trust) or offshore (foreign trust). In this article, we will explore the primary differences between domestic and foreign trusts. 

Table of Contents:

• What Is A Trust?
• What Is An Asset Protection Trust?
• Legal Distinction Between A Domestic Trust And A Foreign Trust
• Main Differences Between A Domestic And A Foreign Asset Protection Trust
• Privacy
• Legal Precedent
• Asset Protection Features
• Statute Of Limitations For Fraudulent Conveyance
• Legal Jurisdiction 
• Cost
• Which Trust Should You Choose

What Is a Trust?

A trust is a legal agreement between three parties (the grantor/settlor, trustee, and the beneficiary) which involves a transfer of assets into the trust for the ultimate benefit of the beneficiary/beneficiaries. The grantor/settlor of the trust usually transfers a portion of their assets into a trust, which are then safeguarded and managed by a third-party trustee. The beneficiary receives those assets or the benefits/income from them at a future point in time in accordance with the terms laid down in the trust. 

What is an Asset Protection Trust?

Before we go onto the nitty gritty of comparing domestic and foreign trusts, it would be good to understand one important type of trust: the Asset Protection Trust (APT). An Asset Protection Trust is a special type of irrevocable trust which allows the grantor to simultaneously be the sole beneficiary of the trust. In this way, they retain all the benefits of the assets they transfer into the trust, while legally removing ownership and placing them in the safe custody of the trust, which is managed by a professional trustee. This provides a strong layer of protection, as creditors are unable to directly claim the assets which are now officially under the legal ownership of the trust itself. 

Asset Protection Trusts exist in various forms all over the world, and it is therefore possible to form one either domestically or in a foreign jurisdiction. As these are the most popular types of foreign trusts which are commonly formed, we will specifically be comparing domestic and foreign asset protection trusts in this article. 

Legal Distinction between a Domestic Trust and a Foreign Trust

Whether a trust is legally deemed a domestic or foreign trust can have tax implications, as well as determine the power of local courts to pass rulings related to the assets in the trust. In the context of the United States, a “domestic” trust specifically refers to a trust that is viewed as a U.S. legal person for federal tax purposes. The same logic applies when we are speaking about domestic trusts in other nations. 

In the U.S., the Internal Revenue Code simply defines a foreign trust as one that is not a domestic trust. So, in order to understand what legally constitutes a foreign trust we need to know the legal criteria for a domestic trust. 

For a trust to be classified as a domestic trust for U.S. federal tax purposes, it must satisfy both of the following criteria:

1. A U.S. court is able to exercise primary supervision over the trust’s administration.
2. One or more U.S. persons have the authority to control all substantial decisions of the trust. 

The first criterion is fairly straightforward. If a trust is formed within the U.S. and therefore governed under U.S. state law, and is administered primarily in the U.S., it will most probably fulfil the first criterion listed above. The second can be a bit more subtle, as it involves careful determination of what a “substantial decision” is. The general definition of a “substantial decision” is a decision that a person is authorised or required to make in accordance with the terms of the trust and appropriate law which is not ministerial in nature. Examples of substantive decisions may include:

• If and when to distribute income or principal from the trust,
• How much to distribute,
• Termination of the trust (only applies to revocable trusts),
• Whether to replace, remove, or add a new trustee (also generally only applies to revocable trusts).

These are some of the major decisions that are considered to be “substantial” for the purpose of defining the trust, but less obvious decisions might also be deemed as substantial, depending on the type of trust, where it is registered, and the perspective of local courts. The second, les clear criteria, allows for clever planning so as to achieve the desired classification of the trust (either domestic or foreign), be it for tax purposes or other reasons. As we mentioned, any trust which does not qualify as domestic according to the above two criteria is considered to be a foreign trust. 

To summarise the key difference between a domestic and foreign trust: it is primarily the domicile of the Trust Agreement that ultimately determines whether a trust is considered to be domestic or foreign. If you are a U.S. resident and the jurisdiction of the trust agreement is within the United States, it is a domestic trust. If the jurisdiction is outside of the U.S., it’s a foreign trust. 

 

Main Differences

Now that the primary legal distinction between a domestic and foreign trust is clearer, we can look into the key differences in the features of these two trusts. We will be discussing the differences specifically with relation to Asset Protection Trusts (APTs).

Privacy

One of the main attractions of setting up an offshore trust is that it provides a much higher level of privacy. For example, in the case of a Cook Islands Trust (widely considered to be the best offshore asset protection in the world), the government only keeps a record of the name of the trust and the trustee. This means that your name, as both settlor and beneficiary, will not be recorded at all. This is commonly the case with offshore trusts in many attractive foreign jurisdictions, such as Nevis, Belize, and Cayman Islands. Furthermore, the records that are kept by these governments remain private, and it is extremely difficult for foreign courts to obtain them. The Cook Islands, for example, does not recognise subpoenas issued by a US court at all

In contrast, a domestic asset protection trust (DAPT), will certainly not offer the same level of privacy. Any trust formed in the US, irrespective of the state, falls under the jurisdiction of the federal government, meaning it is very difficult to acquire the high level of privacy as you would by using an offshore trust.  

Legal Precedent

It is interesting to note that foreign asset protection trusts are actually older than U.S. DAPTs. The Cook Islands International Trust Act was first passed in 1988, compared to the first domestic asset protection trust in the US being the Nevada Asset Protection Trust in 1999. The practical implications of this are that foreign asset protection trusts have more case law behind them, which adds to their security and level of protection. The Cook Islands trust has particularly strong case law proving that it has been extremely successful at protecting assets in a range of circumstances. In this way, the legal precedent of DAPTs is actually somewhat weaker than that of FAPTs.

Asset Protection Features

Statute of Limitations for Fraudulent Conveyance

The top advantage of an offshore APT, especially a Cook Islands trust, is its strong protection against claims of fraudulent conveyance. Fraudulent conveyance is the transfer of assets or property for the specific purpose of putting it out of reach of a known creditor (e.g., transferring your assets to an irrevocable trust after a creditor has made a claim against these assets, or after an event which warrants a claim). In this case, the courts can rule that the transfer was fraudulent and therefore force its reversal in order for you to fulfil your obligations with the creditor.

There are various factors which come into play when determining whether a transfer is indeed fraudulent conveyance, but one of the most important is the statute of limitations. This refers to the maximum time that a creditor has to bring a case of fraudulent conveyance to the table after the cause of the action took place. Cook Islands Trusts have a very short statute of limitations of only two years, compared to more than three years in the US. Once this time has passed, the assets are well protected from claims of fraudulent transfer. 

Legal Jurisdiction 

In addition to the short statute of limitations, offshore trusts provide much greater levels of asset protection due to the trust laws applicable. These laws are much more favourable and protective to the assets held within a trust. Furthermore, these offshore jurisdictions do not recognise court rulings passed by a foreign court. This means that a creditor needs to open a case inside the offshore jurisdiction itself in order to make a claim against your assets. The complexities and costs associated with this are usually enough to deter most creditors. 

 

Cost

Cost is the primary factor that most people consider when deciding whether to use a domestic or foreign asset protection trust. It should be clear by now that FAPTs are generally superior to DAPTs in most areas, but they also come at a significantly higher price. 

The exact difference in associated costs depends on many factors, most importantly the jurisdiction in which the trust agreement is based. In general, a good FAPT can cost anywhere from $20,000 - $50,000 to set up, with high annual maintenance fees. On the other hand, a domestic APT can be formed for well under $10,000, with much lower annual maintenance fees. 

Which Should You Choose

It should be quite obvious that a foreign offshore asset protection trust offers many benefits compared to a domestic trust, primarily in the forms of enhanced asset protection and privacy. The only downsides come in the form of a much higher price tag, and increased complexity and reporting requirements. 

Therefore, deciding which type of trust to use really comes down to your personal circumstances and needs. If you do not feel you need the higher level of protection offered by an offshore trust, then you can probably settle for the cheaper domestic version. If, however, you are a very high net worth individual who is looking for the utmost in asset protection and privacy then it is probably best to spend the extra amount and go with a foreign trust. In either instance, it is recommended to enlist the services of a professional asset protection attorney who can advise you and help guide you through the process at every step of the way.