A recent Illinois case that ruled unfavorably on the use of self-settled trusts, Rush Univ. Med. Center v. Sessions, ____ N.E. 2d ____, 2012 IL 112906, 2012 WL 4127261 (Ill, Sept. 20, 2012) (Rush U), has raised eyebrows from some advisors and drawn yawns from others. Some advisors have concluded that the use of a domestic self settled trust (DAPT) for residents of non- DAPT jurisdictions isn’t viable. Others have pointed out that the result in Rush U was not unexpected in that it’s consistent with prior bad fact cases attacking self-settled trusts. Other advisors are trying to focus efforts on being more cautious in their application of the self settled trust technique. The reality is that, before and after Rush U, DAPTs were and remain unproven. Until the Supreme Court rules on the application of the Full Faith and Credit clause of the constitution as to whether a DAPT jurisdiction has to respect a judgment from a non-DAPT jurisdiction, we won’t know whether creditors can reach a DAPT, whether transfers to a DAPT will be completed gifts or if the assets will be removed from a grantor’s estate for a non-DAPT resident.
Some experts have stated that the Internal Revenue Service has informed them that it refuses to issue rulings on self-settled trusts after Battley v. Mortensen, Adv. D. Alaska, No. A09-90036- DMD, May 26, 2011 (Original Memorandum) and July 18, 2011 (Memorandum Denying Motion For Reconsideration). Will Rush U further reinforce that position and IRS’ negative view about these self-settled trusts? One of the difficulties in evaluating the import of Rush U is that it appears to be another “bad facts” case.
The following simplified time line of the facts concerning Robert W. Sessions, the grantor of the trust, is helpful in understanding the case.
- Feb. 1, 1994—asset protection trust established and funded with family limited partnership (FLP) interests.
- Fall 1995—Sessions made a pledge to a local charity.
- April 19, 2005—Sessions created a revocable trust and contributed his 1 percent general partnership interest to the trust.
- April 25, 2005—Sessions died.
Sessions established an FLP in Colorado. Later, on Feb. 1, 1994, Sessions, as grantor, set up the Sessions Family Trust in the Cook Islands. The trust was a foreign asset protection trust (FAPT). The FAPT was irrevocable, included a “spendthrift” provision and distribution standards permitting distributions to Sessions of income or principal for his “maintenance, support, education, comfort and well-being, pleasure, desire and happiness.” Sessions himself was named trust protector. In this capacity, he retained the power to remove trustees, to veto any discretionary actions of the trustees and to appoint or change beneficiaries in his will.
Sessions transferred 99 percent of the FLP interests and real property located in Hinsdale, Illinois to the FAPT.
In the fall of 1995, Sessions made a pledge to a local charity, Rush University Medical Center, of $1.5 million. The pledge was for the construction of a new president’s house on the university’s campus in Chicago. In reliance on this pledge, the charity built the house and even held a public dedication honoring Sessions. Sessions executed several codicils to his will reflecting that any portion of the pledge that was unpaid at his death should be paid from his estate. On Sept. 30, 1996 Sessions sent Rush University Medical Center another letter confirming the charitable pledge.
On December 15, 2005 the charity filed an amended complaint against Sessions’ estate to enforce the pledge. The third count in the complaint relied on the principle that if the settlor creates a trust for his own benefit it’s void as to existing and future creditors and that those creditors can reach his interest in the trust. This common law rule is supported by a number of Illinois cases, such as Marriage of Chapman, 297 Ill. App. 3d 611, 620 (1988) and Crane v. Illinois Merchants Trust Co., 238 Ill. App. 257 (1925). The court stated the common law rule as follows: “Traditional law is that if a settlor creates a trust for the settlor’s own benefit and inserts a spendthrift clause, the clause is void as to the then-existing and future creditors, and creditors can reach the settlor’s interest under the trust.” The court noted that this conclusion didn’t require that the transfer be a fraudulent conveyance.
The trustees of the FAPT argued that the common law principal stated above was supplanted by the Fraudulent Transfer Act (Act) and that the Act provided specific mechanisms to prove that a transfer was fraudulent. Section 5(a) of the Act provides that:
A transfer made or obligation incurred by a debtor is fraudulent as to a creditor…if the debtor made the transfer or incurred the obligation: (1) with the actual intent to hinder, delay, or defraud any creditor… (2) without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor: (A) was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (B) intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they came due.
Based on Sessions’ conduct, his transfers to his FAPT may not have withstood this test. But, it appears that the complaint filed by the charity did not allege “that the decedent made a transfer to the trusts ‘with actual intent to hinder, delay, or defraud’.” The trustees advocated that the Act superseded common law rights that made a self settled trust fraudulent per se. If the Act did supersede the common law, then the charity would have had to prove that the funding of the trusts was a fraudulent conveyance under the Act.
The appellate court reversed the lower court’s decision and held that the common law cause of action was abrogated by the Act (740 ILCS 160/1 et seq.). The appellate court, as cited by the Supreme Court, found that if the legislature intended self settled trusts to remain per se fraudulent under the common law, it would not have promulgated a statue defining the conditions required to prove a transfer was fraudulent.
The Illinois Supreme Court held that common law creditor rights and remedies remain in full force unless expressly repealed by the legislature or modified by court decision. The reasoning of the Supreme Court can be summarized in its quote from a case from 1898: “…it would make it possible for a person free from debt to place his property beyond the reach of creditors, and secure to himself a comfortable support during life, without regard to his subsequent business ventures, contracts or losses.”
Post-Rush U Planning
Clearly, the planning and implementation in Rush U was flawed. Holding real estate in Illinois, and having the grantor as a trustee and trust protector was inadvisable. There’s another potential line of planning that the Rush U case suggests might increase the potential for the success of a domestic self-settled trust. The Supreme Court dismissed an argument by the trustees of the FAPT that, while it may not have applied in the Rush U case, may be instructive for planning self-settled trusts generally. The trustees argued that once a debtor dies, the creditors no longer have an interest to reach in what had been a self settled trust. The trustees cited Greenwich Trust Co. v. Tyson, 27 A. 2d 166 (Conn. 1942). The Court stated:
But that case is distinguishable and does not support defendants’ position. Unlike the assets in the present case (which the trustees were free to distribute to Sessions), the principal share subject to the relevant holding in Greenwich was not distributable to the settlor unless he lived for 20 more years after the trust was created, which he did not, and the trust further prohibited any alteration of that restriction.
This suggests that restrictions can be incorporated into a self-settled trust, for example, that your client cannot benefit unless your client is not married, or that no distributions can be made to your client until after ten years and a day, etc., that if not triggered would cause the trust to be viewed as not being self-settled. This would also seem to support the position advocated by some that instead of the grantor being named a beneficiary from the inception of the trust, a third party should be granted the power to add a class of people, including the grantor. And, if the grantor is removed as a beneficiary prior to his death (even if within 3 years), the trust would not be includible in his taxable estate.
Another take away from this case may be that a foreign trust should not own assets physically located in the United States (or entities under the settlor’s control), if maximum asset protection is desired. Settlors have to be willing to give up control in exchange for protection. There’s no doubt that if the assets were located offshore, the creditor in Rush U could not satisfy its judgment and, accordingly, the Illinois court’s decision would have no force and effect.
On its face, Rush U is just another bad facts case challenging self-settled trusts. But, perhaps there are some positive planning lessons to be learned.