The Perils of Success: Asset protection to keep the good times rolling
I grew up in Seattle during the ’90s, and that means two things; I still have a fondness for flannel shirts, and I saw a lot of everyday people become millionaires overnight. Bespectacled Microsoft and Amazon engineers cashed in their stock options for a life beyond their parents’ wildest dreams. But with more money comes more problems.
So I watched a recent case out of Delaware, Matter of Daniel Kloiber Dynasty Trust, with intense interest. Daniel Kloiber, a successful technology entrepreneur and Kentucky resident, was embroiled in a contentious divorce with Beth Kloiber. In 2003, Daniel’s father, Glenn, gifted $15,000 to an irrevocable trust in the state of Delaware for the benefit of Daniel, Daniel’s spouse, and Daniel’s descendants. Daniel then sold the stock of his company, Extreme Software, Inc. to the trust in exchange for a promissory note with a value of $6 million. The trust was designed not only to protect the stock from creditor claims, lawsuits, and divorce, but also to “freeze” the value of the stock at its value at the time of the transfer to the trust, so that the stock’s appreciation would not be subject to the estate and gift tax. The unique third-party (in this case, Glenn) founding of the trust gets around the prohibition on self-settled trusts in jurisdictions like Michigan, and allowed Daniel to retain control of the company during his lifetime.
Trusts like these are an attractive option for clients with assets that may greatly appreciate in value, but who still want control of their company. Daniel’s stock appreciated to the tune of about $310 million by 2009, when Daniel sold all his shares to third party investors. Everything went well until the Kloibers divorced, and Beth sought an order to divide the trust.
Daniel and his advisors made two crucial errors when setting up the trust. First, distributions to Daniel were subject to a standard of “health, education, maintenance, and support,” what the law calls an “ascertainable standard.” Usually such trusts are protected from creditor claims, but the Delaware divorce case Garretson v. Garretson held that a divorcing spouse may divide a trust pursuant to a divorce judgment. Michigan has the same law making a divorcing spouse an “exception creditor,” but instead of a case, our exception is codified in the Michigan Trust Code. However, in both Michigan and Delaware, a trust with distributions pursuant to the discretion of a trustee is protected from nearly all creditor claims, including an ex-spouse.
Secondly, the trust allowed Daniel to serve as both the investment and distribution trustee. When the divorce was pending, Daniel tried to resign and transfer his trustee duties to a bank, but his spouse’s lawyers argued that the resignation constituted a fraudulent transfer, and tried to hold Daniel in contempt. In the end the court didn’t need to consider the fraudulent transfer argument. The court held that since Beth was an “exception creditor,” the trust should be severed on that basis alone. Still, the appointment of Daniel as a trustee of a trust this large and complex is puzzling, and undoubtedly, the fraudulent transfer argument will be raised in similar cases in the future.
This case demonstrates a few very important lessons for both business owners and the professionals that advise them. The good news for Michigan residents and advisors is that our laws regarding the issues in this case are codified, which means the outcome of a case like this here should be more predictable. It also undermines the arguments of some trust advisors who try to sell clients on trusts and LLCs in supposed creditor-proof jurisdictions like Delaware, Nevada, and Alaska.
Furthermore, by implication, the court held that a trust with distributions subject to a pure discretionary standard would have been protected from Beth’s claim. In Michigan, such trusts are statutorily protected from these claims. While it is difficult to convince a client to transfer assets that they can only get back pursuant to the discretion of a trustee, advisors should strongly encourage clients to do so when the stakes are so high. A client may serve as the “management” or investment trustee, bifurcating the trustee duties with an unrelated third party trustee serving as the distribution trustee.
This would at least give the client control over the operation of the trust, and its underlying company, while affording the highest level of asset protection.
Finally, the case highlights the importance of sound advice from estate planners that can consider issues beyond just taxes. It’s often family dynamics and other unforeseen circumstances that can derail a plan.
Brandon Dornbusch is a principal attorney at Legacy Legal Group, PLC, where he focuses his practice on estate planning, probate law, real estate, and business issues. He can be reached at (231) 941-5000, or at firstname.lastname@example.org.