Read this before setting up a Foreign Asset Protection Trust.

By Douglass Lodmell, J.D., LL.M. · Founder, Lodmell & Lodmell

After more than 30 years practicing asset protection law and helping protect over $12 billion in client assets, I have reached a conclusion that surprises many people: a Foreign Asset Protection Trust, or FAPT, is rarely the right solution.

That does not mean foreign trusts are ineffective. Quite the opposite. A properly structured Foreign Asset Protection Trust may be the most powerful asset protection vehicle ever developed. In the right circumstances, it can be extraordinarily effective.

The problem is not the protection. The problem is everything that comes with it.

Most attorneys selling offshore trusts spend their time talking about the laws of the Cook Islands, Nevis, or Belize and how difficult it can be for a creditor to reach assets held offshore. Those benefits are real.

What they may fail to explain is that you are also purchasing decades of international tax compliance, recurring professional fees, and exposure to some of the harshest reporting penalties in the Internal Revenue Code. In my opinion, that changes the analysis entirely.

The purpose of asset protection is to reduce risk, not exchange one risk for another

Asset protection planning exists to reduce uncertainty. The lawsuit you fear is uncertain. The IRS reporting burden associated with a foreign trust is not.

The day your Foreign Asset Protection Trust is created, the compliance requirements begin. From year one and every year thereafter, you and your advisors must navigate complex international reporting requirements, coordinate with a foreign trustee, prepare specialized tax filings, obtain valuations of transferred assets, and maintain extensive documentation.

While the lawsuit may never happen, the compliance burden is guaranteed.

The IRS reporting requirements are more serious than many clients realize

Foreign trusts are governed primarily by Internal Revenue Code Sections 6048 and 6677, creating one of the most demanding reporting regimes in the Internal Revenue Code.

The reporting is accomplished primarily through Forms 3520 and 3520-A. These are not simple information returns. Form 3520 requires extensive disclosure of virtually every significant interaction between you and the trust, including:

• Every transfer to the trust, including the date, fair market value, and nature of the property transferred.
• Whether the transfer was a gift, sale, exchange, loan, or another type of transaction.
• The identity of the trustee, grantors, beneficiaries, and related parties.
• Every distribution received from the trust, together with its tax character, fair market value, basis, and supporting beneficiary statements.
• Confirmation that the foreign trustee properly filed Form 3520-A.
• Foreign Grantor Trust Owner Statements, supporting schedules, and required attachments.

For publicly traded securities, determining value may be straightforward. For privately held businesses, LLC interests, real estate, promissory notes, intellectual property, partnership interests, or alternative investments, it often requires professional valuation work at the client’s expense.

Many experienced CPAs do not prepare these returns because of their complexity and instead refer clients to international tax specialists. Fees routinely run from $3,500 for a very simple filing to well over $10,000 for a more complicated filing every year. IRS guidance estimates that completing Form 3520 can require more than 50 hours of work per year.

Penalties may apply when the IRS considers a timely form incomplete, inaccurate, improperly valued, or missing required attachments. You can file every form on time, owe no tax, and still receive a significant penalty because one reportable transaction was omitted or one required disclosure was incomplete.

Fund a trust with $15 million in assets and fail to file correctly, and a 35% calculation can reach $5.25 million. These are reporting penalties, not tax evasion penalties.

For clients with very large estates, often over $30 million, or unusually acute risks, the cost and complexity may be justified. For many clients below that threshold, the burden is often not justified.

The Bridge Trust®

The Bridge Trust® was designed to preserve access to the protective characteristics that make Foreign Asset Protection Trusts so effective while avoiding the foreign trust reporting regime during ordinary domestic administration.

Rather than immediately placing clients into decades of Forms 3520 and 3520-A, foreign trustee administration, and international tax reporting, the Bridge Trust® is structured to satisfy the two-part test under Internal Revenue Code Section 7701 and be treated as a domestic trust for U.S. tax purposes during its domestic phase.

Ordinary U.S. grantor trust compliance applies during that phase. Often, the trust does not require a separate income tax return because its activity is reported on the grantor’s individual return. Forms 3520 and 3520-A generally do not apply while the trust remains domestic.

At the same time, the trust is registered offshore in the Cook Islands, Nevis, or Belize, receives an offshore registration certificate, and has an offshore Special Successor Trustee already in place. The trustee is a party to the trust instrument and accepts that role at formation.

If extraordinary circumstances arise and the trust’s protective provisions are properly activated, it may fail the court test, the control test, or both. It is then no longer considered domestic for U.S. tax purposes. Its offshore registration was already established. The change concerns administration and U.S. tax classification.

Foreign trust reporting, including Forms 3520 and 3520-A, generally applies once the trust is classified as foreign. For the overwhelming majority of clients, that day never comes.

As a result, clients can preserve access to offshore protection while avoiding years, and often decades, of unnecessary foreign reporting, recurring compliance costs, and exposure to international reporting penalties during ordinary domestic administration.

My recommendation

Foreign Asset Protection Trusts remain exceptional tools for the right client. If someone has $40 or $50 million or faces unusually high litigation risk, the additional complexity may be entirely justified.

But in my experience, that is not most clients. My average client has significant wealth that needs protection but does not need to be subjected immediately to such onerous reporting requirements and risks.

In these cases, the more appropriate solution is one that provides outstanding asset protection without voluntarily entering one of the most burdensome international reporting regimes in the Internal Revenue Code. The Bridge Trust® provides exactly that: access to offshore protection when needed and simpler domestic compliance when it is not.

If you are considering an asset protection trust, determine which compliance regime you are choosing. If a fully foreign trust seems appropriate, your CPA and tax advisors should be part of the decision, and responsibility for each accounting and filing requirement should be determined before you establish the trust.

This is how I work with my clients. When I recommend a fully foreign trust, I require the client to connect me with the client’s CPA from the beginning. I also explain the costs and requirements directly. I would rather have a client pleasantly surprised when annual expenses come in at $14,000 than stunned and upset.

Working with an experienced attorney who is comfortable with both a fully foreign trust and a Bridge Trust® is one of the most important decisions you will make. You receive a more balanced analysis when all options are on the table.

In the end, you are the person who must maintain the structure. Experienced advisors can help, but choosing the best plan for you is ultimately your responsibility.

Lodmell & Lodmell, P.C. is one of the nation’s leading asset protection law firms and the creator of The Bridge Trust®. We serve clients nationwide and may be reached at support@lodmell.com or 602-230-2014.