Elder Counselor Newsletter Alter Ego Doctrine and Busting of a Protective Trust

Our firm produces Estate Planning Advisors to provide a quick summary of estate and gift tax planning, elder law planning, asset protection planning, and other items we believe may be of interest to our financial and accounting professional colleagues. This Advisor deals with the concept of the Alter Ego Doctrine, and protecting assets held in a trust from, the creditors of the trust creator, termed the Settlor for purposes of this Advisor.

The impetus for this subject matter is the result of a recent case in the 9th Circuit Court of Appeals, essentially the far Western states, but the legal principles stated in the case are, for the most part, uniform among the states.

9th Circuit and the Alter Ego Doctrine – In re Schwarzkopf

Q1. How are trusts used for asset protection?

A1. Actually there are multiple ways that trusts are used for asset protection. In this case, the Debtor created three trusts, two are primarily discussed, the Grove Trust and the Apartment Trust, for the benefit of their daughter. This type of use for asset protection is termed a third party settled trust. By that, is meant that the beneficiary of the trust is someone other than the Settlor. It is generally believed that if the Settlor sets up a trust for someone else that the assets in the trust are protected from the creditors of the Settlor.

Q2. What is the theory that protects the assets from the creditors of the Settlor?

A2. Generally, a person is entitled to give their property to anyone they wish, provided the gift is bona fide, and not considered a transfer intending to “hinder, delay, or defraud” a creditor. We will deal with “hinder, delay, or defraud” in subsequent Advisors. If the gift is to a trust for the benefit of a beneficiary, other than the Settlor, the trust usually prohibits the beneficiary from pledging, selling, assigning, or otherwise disposing of the trust property or the beneficiary’s interest in the trust. This limitation was devised to keep beneficiaries, deemed spendthrifts, from wasting their interest in the trust. Thus, such trusts are referred to as “Spendthrift Trusts.”

Q3. How does the alter ego doctrine enter in the asset protection for third party spendthrift trusts?

A3. Now to the meat of the matter, we prefer, when we can, to use language quoted from the case we are discussing, Schwarzkopf in this instance, to provide the explanation. As a general rule, the judges do a better job of explaining what they mean than we would reporting it second hand, so here goes:

Robert L. Goodrich, the Chapter 7 trustee for the bankruptcy estates of Alex Michaels, aka Alexis Michaels, aka Alex Schwarzkopf (“Michaels”), and Joanne Louise Michaels, aka Joanne Louise Schwarzkopf (collectively,“the Debtors”), seeks to recover for the estates’ benefit approximately $4 million in assets.

Goodrich alleges that the Michaels… transferred those assets to two irrevocable trusts known as the Apartment Trust and the Grove Trust and that the district court erred in holding that neither trust is one of Michaels’s alter ego…

Michaels created both the Apartment Trust and the Grove Trust on June 15, 1992. They named their minor child, Sydnee Michaels (“Sydnee”), beneficiary and appointed Juan Briones (“Briones”) trustee…

The only asset placed into the Grove Trust at its inception was $25.00. In December 1997, however, Michaels’s company Impetrol Corporation purchased four lots of land containing avocado groves (“the Grove Lots”) for the Grove Trust. The bankruptcy court noted that the assets used to acquire the Grove Lots belonged to Michaels and that “Im-petrol was nothing but a shell …to put properties in the corporate name.” It found that the Debtors were insolvent at the time of the purchase and that “[t]he Grove Trust’s acquisition of the Grove Lots was a fraud on the creditors of the Debtors.” It also found that Michaels dominated and controlled all decisions related to both the Grove Lots and the Grove Trust and that “Briones had no role nor took any action… other than to write checks as demanded by Michaels.” The Grove Trust paid Michaels at least $105,000 in unexplained fees from February to September 2002. (Emphasis supplied)

Note how the court is beginning to illustrate the control that Michaels had over the trustee, Briones, and how the assets of the Grove Trust were distributed to Michaels, despite the fact that Michaels’ daughter was the alleged beneficiary. The court continued:

Although the trusts paid for Sydnee’s education, clothing, medical care, car, and golf lessons and tournament expenses, the Debtors also benefitted from both trusts. The bankruptcy court found that “Mr. Briones provided payments to Mr. Michaels from both the Grove Trust and the Apartment Trust without complete documentation” and that, “[t]hrough his influence over Mr. Briones, Mr. Michaels received advances and expedited payments from either the Apartment Trust and/or the Grove Trust to avoid a creditor about to levy on a judgment against him.” Michaels asked for and received reimbursement from one of the trusts for another daughter’s wedding and for a life insurance policy; Briones testified that he did not know who Michaels named as the policy’s beneficiary. The Debtors lived rent-free with Sydnee in a manufactured home that the Grove Trust purchased after acquiring the Grove Lots and in a house in Temecula, California that the Apartment Trust purchased in 2003.

Briones maintained no books or records for either trust prior to 2000 and often intermingled their funds. The trusts shared a bank account from October 2002 through January 2003, Briones transferred money between the trusts when he determined that one needed more, and the Apartment Trust made purported “loans” to the Grove Trust that were not documented, had no terms for repayment, and were never repaid. The trusts also paid each other’s expenses. For example, the parties stipulated that the Grove Trust paid “various amounts for the maintenance” of the Temecula, California property held by the Apartment Trust, and that the Apartment Trust paid water bills and trustee fees for the Grove Trust. (Emphasis supplied)

The court clearly provides a trail of facts that will, most certainly be used to find that the Grove and Apartment Trusts was the alter ego of Michaels, and his creditors will be able to access the assets of the Grove and Apartment Trusts to satisfy their claims. The final holding is:

Given that Michaels’s equitable ownership is sufficient to meet the ownership requirement, the bankruptcy court did not clearly err in finding an alter ego relationship. See Towe Antique Ford Found., 999 F.2d at 1391 (alter ego determinations are typically findings of fact reviewed for clear error). As the bankruptcy court found, Michaels “dominated and controlled all decisions of the Grove Trust.” He also received payments from the trusts without documentation and to avoid a creditor and diverted assets to the detriment of his creditors, using his assets to acquire the Grove Lots at a time when he was insolvent. Given that the bankruptcy court called the acquisition of the Grove Lots “a fraud on the creditors of the Debtors,” failure to find alter ego liability would sanction a fraud or promote injustice. The bankruptcy court did not err in finding that the Grove Trust is Michaels’s alter ego. (Emphasis supplied)

The Apartment Trust was found to be invalid for, essentially the same rationale, but the alter ego doctrine is more fully explained in the Grove Trust circumstances.

Q4. So, is it true that not recognizing the formal relationships between a Settlor and the Trust, and failing to respect those relationships likely will impose the alter ego doctrine on the Settlor?

A4. Couldn’t have said it better myself.

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category: Estate Planning Advisor

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