Friday, November 6, 2015

Off Shore Trusts: The SEC is Looking; Not Just the SEC

In the last 40 years, the estate planning world has, in the parlance of some, divided into “domestic” and “off shore” practice areas.  As part of the response to U.S. citizens using off shore trusts, the Treasury Department instituted income tax reporting requirements and the bankruptcy  courts addressed whether language in off shore trusts prevents creditors in the United States from reaching the assets and compelled compliance by holding the trust beneficiaries in contempt.  The Federal Trade Commission has weighed in. Recently in a Securities and Exchange matter, civil disgorgement and prejudgment interest imposed by the Southern District Court of New York against two brothers, Texans (one deceased), will probably result in an ever greater chill factor on taxpayers and their counsel practitioners when considering the use of off shore trust planning.  Securities and Exchange Commission v. Wyly and Miller, Executor, 10-cv-5860-SAS (S.D. N.Y. 2014).

U.S. citizens, resident aliens, and certain nonresident aliens must report worldwide income from all sources, including foreign accounts.  Income from those accounts is taxable in the U.S.  The Internal Revenue Service recognizes that there are many legitimate reasons for holding off shore accounts, including convenience, investing, and facilitation of international transactions.  (Often, off shore trusts are referred to as “offshore asset protection trusts” or “OAPTs”.) To use an off shore trust or entity to avoid the payment of tax is not allowed. In most cases, taxpayers with off shore assets need to fill out and attach Schedule B to their income tax returns; Part III of Schedule B requires information about foreign accounts and usually requires reporting of the country in which each account is located.  Certain taxpayers may also have to fill out and attach IRS Form 8938, Statement of Foreign Financial Assets. Additional filing requirements apply to those with foreign trusts.

Another requirement is that a taxpayer whose foreign accounts are greater than $10,000 at  any time during the year must file by June 30 each year Form 114, Report of Foreign Bank and Financial Accounts (FBAR) electronically through FinCEN’s BSA E-Filing System.  (For more details on reporting for foreign accounts, see, “Reporting Requirements for Foreign Accounts”, 39 Tax Management Estates, Gifts and Trusts J. 140 (Bloomberg USA No. 3, May-June 2014)).

Bankruptcy courts that have considered off shore trusts (created under the laws of the Cook Islands, Jersey Channel Islands, Bermuda, for example) have held that the situs for determining if creditors are able to reach the assets is determined under U.S. situs law, not the situs of the OAPT.  In re Portnoy (Marine Midland Bank v. Portnoy), 201 B.R. 685 (Bankruptcy, S.D. N.Y. 1996 ; In re Butler, 217 B.R. 98  (Bankruptcy, D. Conn. 1998); In re Lawrence (Goldberg v. Lawrence), 227 B.R. 907 (S.D. Fla. 1998); aff’d, 251 B.R. 630 (S.D. Fla. 2000, affirming turnover, contempt, and jail time where a self-settled off shore trust in the Mauritas was in issue), aff’d, 279 F.3d 1294 (11th Cir. 2002).

Cases outside of the bankruptcy court have also held that repatriation of off shore trusts’ assets can be ordered where the settlor may have directed that a “protector” can change the trustee.  See the Federal Trade Commission case known colloquially as the “Anderson case” (discussed more below) where a court held both Mr. and Mrs. Anderson in contempt when they refused to repatriate assets in a trust in the Cook Islands and let them do some jail time.
Federal bankruptcy courts are not the only place where U.S. Federal law and the interests underlying the law are used to prevent assets in an off shore trust from being reached by the U.S. citizen’s creditors.  In 1999, the Federal Trade Commission became interested in the off shore trust world.  Federal Trade Commission v. Affordable Media, LLC, 179 F.3d 1228 (9th Cir. 1999) deals with a couple with a Cook Islands trust that had a provision directing any foreign trustee to refuse repatriation if the couple was under “duress”. Why was the FTC interested?  Did you ever see those late-night television infomercials about investing and selling bar bells that could be filled with water and also investing and selling talking pet tags?  The Andersons made millions in what has been described as a Ponzi scheme where they took fees from investors who were never able to recover their investment, much less make money, and then moved the monies off shore.

The interest of the Securities and Exchange Commission has grown over the last 14 years when citizens’ actions really cross the line, resulting in convictions for securities fraud and conspiracy to defraud the United States.  In Securities and Exchange Commission v. Bilzerian, 112 F. Supp. 2d 12 (2000), the taxpayer, after the SEC started proceedings against him, transferred assets to a “complex ownership structure of off-shore trusts and family-owned companies and partnerships.”

More recently, in May 2014,  the Southern District Court of New York held Samuel Wyly and his deceased brother, Charles Wyly, liable for civil fraud in failing to report stock sales by 4 off shore trusts and subsidiary entities (in the Isle of Man) and profits of $553 million:  $123.8 million again Samuel, $63.9 million against Charles and his estate, with prejudgment interest that could result in $300 to $400 million in penalties.  The Wylys sat on the boards of the publicly-traded companies in which the off shore trusts and entities traded, including holding warrants and options.  The judge’s decision included a finding that the Wylys did not continue to file required reports with the SEC after transfers to the off shore trusts because they did not want there to be “inconsistent positions in their SEC and IRS filings when millions of dollars were at stake.”  (The SEC also sued the family’s lawyer – a former Jackson Walker partner and Jones Day consultant, who entered into a settlement agreement before the Wylys’ trial admitting wrongdoing and agreeing to pay $795,000; he also testified at trial.  The Texas State Bar Association website indicates that this attorney is now “retired”.  (The attorney whose seminars led to his consultation on off shore trusts for the Wylys later went to Federal prison for felony money laundering and gambling.)

Of note is that lawyers’ memoranda and meeting summaries were admitted into evidence.  Clearly, there were repeated discussions about the grantor trust status of the off shore trusts for income tax purposes and whether purchase of options and warrants resulted in the off shore entities having taxable, reportable income and also whether renouncing citizenship could help avoid income taxes in the United States.  Also, the court learned of a non-name meeting between three of the brothers’ attorneys and IRS officials in 2003 (before the IRS had initiated an investigation) to discuss voluntary disclosure; the attorneys learned that the IRS was very interested in whether or not SEC requirements had been ignored.  (There is no discussion of the attorney-client privilege and one cannot but wonder if attorney advice will be used routinely in future cases by federal entities to help convict clients of federal crimes and hold them liable for civil penalties.  If so, will the attorney advice also be used to prevent the attorney from practicing before the Federal entity or affect the attorney’s license in the state(s) of practice?).

The judge (Judge Shira A. Scheindlin) recognized that the penalties being imposed were large, quite large: “By any reasonable measure, the disgorgement and prejudgment interest awarded in this proceeding will be staggering and among the largest awards ever imposed against individual defendants.”

The SEC and defendants had six attorneys on each side.  The defendants’ attorneys were all with the same law firm in three different offices, Dallas, Houston, and New York.

Conclusion:  The Federal government wants more and more information about off shore trusts, investments, and companies in which U.S. citizens have interests.  Clients with off shore interests should expect inquiries in one or more of the following areas: (1)  Bankruptcy – especially choice of law being that of the settlor/beneficiary and not (necessarily) that of the state or off shore jurisdiction where the trust was purportedly established; also Congress has changed the Bankruptcy Code to say that any transfer to a self-settled trust within 10 years of bankruptcy can result in trust being included in the bankruptcy estate (11 U.S.C. § 548(e(1)); (2) Federal Trade Commission – if the activities that generated the monies (that are then invested off shore) violated FTC rules (which has clearly happened, but is not necessarily going to be a frequent occurrence), the weight of the Federal government is likely to be exercised through the Federal Trade Commission; (3) Securities and Exchange Commission – the SEC is pursuing citizens and their off shore trusts and entities when one does not comply with SEC reporting rules; and (4) IRS – the Wyly opinion indicates that the IRS has an investigation open into the income taxes that would have been paid had there been no off shore trusts and subsidiary entities (companies).  Between 1992 and 2002, income related to exercise of options and warrants transferred (some by sale) to the offshore trusts and then sold was not reported by 4 public U.S. companies on whose boards the Wylys sat as the Wylys’ position was that the offshore trusts were not taxable in the U.S.  The Federal Judge disagreed, holding that the offshore trusts were grantor trusts as described in Section 674 of the Internal Revenue Code and must disgorge an amount equal to the taxes avoided on profits relating to the exercise of options and sale of stock in the 4 companies where the Wylys were influential insiders (about $112 million for Sam Wyly and $59 million for Charles Wyly).  Section 674 of the Internal Revenue Code treats a grantor as an owner of a trust when the beneficiary enjoyment of that trust “is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party” and that the trustee physically located in the Isle of Man was not an independent trustee and followed dictates delivered by the Wylys.

For a discussion of the possible rather serious fallout in the income tax arena of the Wyly court’s discussion of the offshore trusts as grantor trusts for income tax purposes based on the manner in which the offtrusts operated on a day-to-day basis (and not on the actual provisions in the documentation), see Akers, Resurrection of “De Facto Trustee” Concept – Securities Exchange Commission v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014), at

Thus, offshore trusts face not only creditors bringing actions in state court, but various Federal agencies attacking positions taken by the settlors and beneficiaries of such trusts.

Kathleen Ford Bay