Tennessee’s Investment Services Act
A Monumental Change in Tennessee Trust Law
By Darsi Newman Sirknen

On May 10, 2007, Gov. Phil Bredesen signed the Tennessee Investment Services Act of 2007 (the Tennessee Act) into law,[1] thereby working a sharp reversal of a major tenet of Tennessee trust law. The act, effective July 1, 2007, allows a grantor to create an “Investment Services Trust,” retain an equitable interest in the trust assets, and yet protect those assets from claims of the grantor’s creditors. Prior to passage of the Tennessee Act, Tennessee (along with the great majority of other states) had been following English common law in holding that self-settled spendthrift trusts (that is, trusts that are established by a grantor for his or her own benefit but designed to protect the trust assets from the grantor’s creditors) are invalid as against public policy.[2]

Several foreign countries (including the Bahamas, the Jersey Islands and Nevis) have recognized self-settled spendthrift trusts for quite some time, which has prompted many United States citizens to expatriate assets in an attempt to protect those assets from their creditors.[3] Perhaps recognizing that economic opportunities were passing them by, a few domestic states have begun to allow self-settled spendthrift trusts (also known as “asset protection trusts”). In 1997, Alaska became the first state to enact such legislation, followed by Delaware (later in 1997), Rhode Island and Nevada (both in 1999), Utah (in 2003), Missouri (in 2004) and South Dakota (in 2005). The purpose of this article is to analyze the provisions of the act and to compare those provisions with the statutes of the seven other states that currently allow some form of asset protection trust.

The Investment Services Trust Under the Act
Tennessee’s Investment Services Act is, with a few important exceptions, identical to Delaware’s and South Dakota’s Qualified Dispositions in Trust Acts. Under the Tennessee Act, a trust instrument must meet four specific requirements before the trust created under that instrument will qualify as an Investment Services Trust. First, the instrument must appoint a “qualified trustee.” Next, the trust instrument must expressly incorporate Tennessee law, and it must contain a spendthrift clause prohibiting both voluntary and involuntary alienation of the beneficiary’s interest in the trust. Finally, the trust must be irrevocable. While Alaska and Utah both require that at least some of the trust assets be cash or cash equivalents,[4] the Tennessee act places no restrictions on the type of assets that a grantor can transfer to an Investment Services Trust.

The act defines “qualified trustee” as a natural person who is a resident of Tennessee or an entity (such as a bank or trust company) that is authorized by the State of Tennessee to act as a trustee. Under no circumstance is the grantor himself a “qualified trustee.” If the qualified trustee is an entity, its activities must be “subject to supervision by the Tennessee department of financial institutions, the federal deposit insurance corporation, the comptroller of the currency, or the office of thrift supervision.”[5] The act allows the grantor to appoint additional trustees who are not “qualified trustees,” but it prevents a grantor from appointing a “figurehead” qualified trustee and allocating all trust responsibilities to a non-qualified trustee by requiring that the qualified trustee maintain some or all of the trust property within Tennessee, engage in trust record-keeping or tax return preparation within Tennessee, or “otherwise materially participate[] in the administration of the … Trust.”[6]

One feature that Tennessee borrowed from the Alaska trust legislation is the requirement that the grantor execute a solvency affidavit before transferring property to an Investment Services Trust. No other state requires such an affidavit. In Tennessee, a “qualified affidavit” must state the following:

1. The transferor has full right, title, and authority to transfer the assets to the trust;
2. The transfer of the assets to the trust will not render the transferor insolvent;
3. The transferor does not intend to defraud a creditor by transferring the assets to the trust;
4. The transferor does not have any pending or threatened court actions against the transferor, except for those court actions identified by the transferor on an attachment to the affidavit;
5. The transferor is not involved in any administrative proceedings except for those administrative proceedings identified on an attachment to the affidavit;
6. The transferor does not contemplate filing for relief under the provisions of the federal bankruptcy code; and
7. The assets being transferred to the trust were not derived from unlawful activities.

A noticeable difference between the Alaska affidavit and the Tennessee affidavit is that Alaska also requires a statement that, “at the time of the transfer of the assets to the trust, the settlor is not currently in default of a child support obligation by more than 30 days.”[7] By removing that statement from its affidavit, Tennessee’s act arguably would allow the grantor of a trust to create a valid Investment Services Trust even though the grantor is more than one month behind in his or her child support payments.

Similarly, the Delaware act, on which the Tennessee act was modeled, includes an exception that allows a spouse, former spouse, or child of the grantor to reach trust assets in order to satisfy claims for alimony, division of marital property, or child support notwithstanding the statute of limitations applicable to other creditors’ claims.[8] That exception is noticeably missing from the Tennessee act.

Nevada is the only other state that allows self-settled spendthrift trusts and provides no exception for alimony and child support claims, although a few of the states’ exceptions are more narrowly tailored than the Delaware exception.[9] As a practical matter, however, there is likely an “unwritten exception” for alimony and child support claims in Tennessee, as it is certainly against public policy to allow a settlor to benefit from trust assets while his or her children and/or former spouse become wards of the state.[10]

Creditor Claims
The Tennessee act does not allow creditors to bring actions to set aside the grantor’s transfer of property to an Investment Services Trust unless (1) the creditor’s claim arose prior to the transfer, and the action is brought within the time limitations set forth in Tennessee’s Uniform Fraudulent Transfer Act[11]; or (2) the creditor’s claim arose after the transfer, and the action is brought within four years after the transfer.[12] Thus, if a creditor’s claim arises more than four years after the property is transferred to the Investment Services Trust, his claim is automatically time-barred.

While most other asset protection trust states employ a four-year period similar to that of Tennessee’s act, Nevada’s act is more aggressive in barring creditor claims. It allows transfers to be set aside only if (i) the creditor’s claim arose prior to the transfer and the action is brought within two years after the transfer is made or within six months after the creditor discovers or should reasonably have discovered the transfer; or (ii) if the claim arises after the transfer is made and the action is brought within two years following the transfer.[13] Utah’s act allows creditor claims only if they arise prior to the transfer or within three years after the transfer.[14]

If a grantor makes several transfers to an Investment Services Trust over time, the Tennessee act provides that any subsequent transfer is disregarded in determining whether property previously transferred to the trust is protected from creditor claims under the four-year rule.[15] Additionally, any distributions made from the trust to the beneficiary are considered to have been made from the property that constituted the most recent transfer to the trust.[16] For example, assume that the following events occur in the following order: a grantor makes an initial transfer of $100,000 to an Investment Services Trust, four years pass without any creditor claims, the grantor transfers another $100,000 to the trust at that time, the trust makes a $40,000 distribution to the grantor, and a creditor files a claim against the trust immediately following that distribution. Because of the rules discussed in this paragraph, only $60,000 of the trust assets would be subject to the creditor’s claim. The full $100,000 of the initial transfer is protected under the four-year rule because the $40,000 distribution is deemed to have been made from the most recent transfer. Thus, only the $60,000 remaining in the Investment Services Trust from the most recent transfer is vulnerable to the creditor’s claim.

One caveat with respect to Tennessee Investment Services Trusts (and with respect to the self-settled spendthrift trusts allowed by other states) is that the Full Faith and Credit Clause of the United States Constitution may impair the trusts’ effectiveness. Because the Full Faith and Credit Clause requires each state to give effect to judgments rendered in other states,[17] if the courts of any other state besides Tennessee had jurisdiction over either a Trustee (if, for example, one of the trust’s co-trustees were a resident of another state) or trust assets (if the trust held any property located outside of Tennessee), a creditor could bring an action against the trustee or against the assets in that state. If that other state, not recognizing the validity of self-settled spendthrift trusts, renders a judgment against the trustee or the trust assets, then the Full Faith and Credit Clause may require Tennessee courts to enforce that judgment and declare invalid the entire transfer of property to the Investment Services Trust.

Interestingly, although self-settled spendthrift trusts have been allowed in certain states since 1997, there are no published cases in which this issue has been considered. The best way to avoid this unfavorable result is to ensure that the trust has no connection with any other state, with the possible exception of the other seven states that recognize the validity of self-settled spendthrift trusts.

In case the isolationist approach noted above is not a viable option, the Investment Services Act anticipates potential claims under the Full Faith and Credit Clause, and it attempts to solve the problem by providing that, if any court declines to apply Tennessee law in determining the effect of a spendthrift provision contained in an Investment Services Trust, then the trustee of the trust “shall immediately upon such court’s action … cease in all respects to be a trustee … and a successor trustee shall thereupon succeed as trustee in accordance with the terms of the trust.”[18] Upon ceasing to be trustee, the exiting trustee has no power over trust assets other than to convey them to the successor trustee. Thus, if a creditor obtains a judgment against a trustee, that judgment may be rendered useless because that particular trustee will have no further authority to convey the trust assets to the creditor. In theory, the creditor would then have to sue the successor trustee and, upon a similar judgment, that trustee would cease to be trustee. Presumably, this cycle could continue ad nauseum until the creditor chose to roll over and accept defeat.

In the event a creditor actually succeeds in having the grantor’s transfer of assets to the trust set aside, the Tennessee act provides that the transfer is set aside only to the extent necessary to satisfy that particular creditor’s claim, plus attorneys’ fees and costs. Thus, any amount in excess of that creditor’s claim remains protected in the trust, and if another creditor later wishes to have the transfer set aside, he must file his own claim (and go through the same cycle of trustee removal/replacement) in order to have a chance at reaching trust assets.

Another protection measure provided by the Tennessee act is that, if a court finds that the trustee did not act in bad faith in accepting or administering the property transferred to the trust (and there is a presumption that the trustee did not act in bad faith), the trustee has a first lien against the trust property in an amount equal to the entire cost incurred by the trustee in the defense of any action to have the transfer set aside. Thus, a creditor could potentially bring a successful action to set aside the transfer of property to the trust and still receive no payment (or at least receive a reduced payment) in the event that the trustee’s legal fees equal or exceed the amount of property held in the trust. This provision of the act would further serve to dissuade creditors from incurring the expenses of a lengthy transfer avoidance action by warning them that there may be no trust property left by the time the court renders a judgment.

Not only does a trustee have a paramount lien on the trust property, but the Tennessee act also bars creditors from bringing suits against the trustee personally when they are unable to reach trust assets. In fact, the Tennessee act protects not only the trustee but also any trust advisor and “any person involved in the counseling, drafting, preparation, execution or funding of an Investment Services Trust.”[19] This protection extends to direct suits to obtain payment of a claim, as well as to collateral suits to enforce a judgment obtained in another state.

Permissible Retained Powers of the Transferor
The most significant feature of the Investment Services Trust is that the grantor can enjoy the broad asset protection discussed above while retaining a degree of beneficial enjoyment and control over the protected assets. The Tennessee act allows the grantor to name trust “advisors,” who have authority under the trust instrument to remove and appoint qualified trustees; direct, consent to, or disapprove trust distributions; or direct, approve, or consent to trust investments. In fact, the grantor himself may serve as an investment advisor to the trust, and he may also retain the right to remove trustees and advisors and to appoint new ones, provided that he does not appoint someone who is related to or subordinate to him within the meaning of Internal Revenue Code (I.R.C.) § 672(c).[20]

The Tennessee act also allows the grantor to retain a power to veto trust distributions. The importance of this power lies in the fact that, once trust assets are distributed to the grantor, they are no longer protected by the trust. Once the assets are in the grantor’s hands, his creditors can sue him directly to reach the assets (assuming he has not already spent them). If the grantor falls into creditor trouble after the four-year creditor claim window has passed, he can simply require that the trustee not make any distributions of trust assets to him until the applicable statute of limitations has run on the creditor’s claim.

Other significant powers the grantor can retain under the Tennessee act include the right to receive all trust income (not just the possibility of discretionary distributions); the right to receive income or principal from a charitable remainder unitrust or charitable remainder annuity trust, as defined in I.R.C. § 664; the right to receive up to five percent of the trust principal each year; and the potential to receive additional principal distributions in the discretion of the trustee or pursuant to an ascertainable standard (for health, education, support or maintenance). The Tennessee act is more expansive than the acts of many other self-settled spendthrift trust states in that it allows the grantor to retain the right to receive trust distributions. Only Delaware and South Dakota also allow a trust grantor to retain the right to trust distributions.[21]

Additional powers that the Tennessee act allows the grantor to retain include a special testamentary power of appointment over trust assets (exercisable in favor of anyone except the grantor, the grantor’s estate, the grantor’s creditors, or the creditors of the grantor’s estate); and the right to use real property owned by the trust if the trust is a qualified personal residence trust, as defined by I.R.C. § 2702(c). Obviously, the grantor is not required to retain all of the enumerated powers, but the significance of the act is that he can retain some or all of the powers without disqualifying the trust and losing its asset protection benefits.

Rule Against Perpetuities
The final sections of the Tennessee act amend Tenn. Code Ann. § 66-1-202, which sets forth Tennessee’s Rule Against Perpetuities (RAP). Until passage of the Tennessee act, any contingent (i.e., nonvested or discretionary) interest in trust was invalid unless it was certain to either vest or terminate no later than 21 years after the death of a person who was alive at the time of the interest’s creation (i.e., the transfer of property to an irrevocable trust); or 90 years after the interest’s creation.[22] The Tennessee act adds a third option for satisfying the RAP.

If certain requirements are met, the Tennessee act validates a contingent interest in trust as long as the interest must either vest or terminate within 360 years.[23] In order for this option to apply, the trust must grant a testamentary power of appointment “to at least one member of each generation of beneficiaries who are beneficiaries of the trust more than 90 years after the creation of the interest.”[24] The permissible appointees of the power must include all descendants of the power holder, but the trust can also include other persons.

As an example, if a grantor creates an irrevocable trust in July 2007, and if his or her great-grandchildren are the beneficiaries of the trust 90 years later in 2097, the trust instrument must give at least one of the great-grandchildren a testamentary power of appointment over trust property.[25] The trust must also provide that at least one member of each generation from the great-great-grandchildren on down must have a testamentary power of appointment that can be exercised if the previous generation’s power holder fails to exercise his or her power of appointment. Thus, this new RAP option could allow a trust to continue for up to 360 years (if no beneficiary exercises a power of appointment), but the trust could also terminate upon the death of the first generation of beneficiaries to have a power of appointment, if that generation exercises its power with respect to all of the trust property.

Conclusion
The Investment Services Act is a significant and, quite frankly, surprising development in Tennessee trust law. By becoming only the eighth state to recognize the validity of self-settled spendthrift trusts, Tennessee has placed itself on the forefront of this emerging trend. Only time will tell whether this trend will eventually spread to a majority of states or wilt under harsh criticism based on public policy and creditor rights considerations. In any event, the Tennessee act is certain to generate interest (and probably heated debate) among attorneys, CPAs, trust companies, financial planners, affluent clients, and others interested in wealth management and asset preservation.

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Notes

1. See 2007 Tenn. Pub. Acts 144 (hereinafter referred to as the “Investment Services Act”).
2. See, e.g., Tenn. Code Ann. § 35-15-505; State v. Nashville Trust Co., 190 S.W.2d 785, 790 (Tenn. Ct. App. 1945); Citizens’ Nat’l Bank v. Watkins, 150 S.W. 96, 97 (Tenn. 1912); J.S. Menken Co. v. Brinkley, 31 S.W. 92, 93-95 (Tenn. 1895).
3. An estimate from the year 2000 indicated that approximately 100,000 American citizens had settled offshore trusts and that the total amount of American money held in offshore trusts was in excess of $1 billion. See Henry J. Lischer Jr., Domestic Asset Protection Trusts: Pallbearers to Liability?, 35 Real Prop. Prob. & Tr. J. 479, 502 (2000).
4. Alaska Stat. § 13.36.035(c)(1) (Michie 2006); Utah Code Ann. § 25-6-14(1)(a) (2007).
5. Investment Services Act § 2(12)(A).
6. Id. § 2(12)(B).
7. Alaska Stat. § 34.40.110(j)(6).
8. Del. Code Ann. tit. 12, § 3573 (2007).
9. See Alaska Stat. § 34.40.110(l); Mo. Rev. Stat. § 456.5-503(2) (2007); R.I. Gen. Laws § 18-9.2-5(a) (2007); S.D. Codified Laws § 55-16-15(1) (Michie 2006); Utah Code Ann. § 25-6-14(2)(c)(v) and (ix).
10. See Restatement (Third) of Trusts § 59 cmt. b (2003).
11. Under the Tennessee Uniform Fraudulent Transfers Act, actions to set aside fraudulent transfers must be brought “within four (4) years after the transfer was made or the obligation was incurred” or, if the transfer was made with the intent to defraud a creditor, “within one (1) year after the transfer or obligation was or could reasonably have been discovered by the claimant,” if that date is later than the four-year date provided above. Tenn. Code Ann. § 66-3-310.
12. Investment Services Act § 4(b)(2).
13. Nev. Rev. Stat. § 166.170 (2007).
14. Utah Code Ann. § 25-6-14(c)(i).
15. Investment Services Act § 4(f)(1).
16. Id. § 4(f)(2).
17. U.S. Const. Art. IV, § 1.
18. Investment Services Act § 4(g).
19. Id. § 4(d) and (3).
20. I.R.C. § 672(c) defines “related or subordinate party” as the grantor’s spouse, parent, descendant, sibling, or employee; or a corporation or any employee of a corporation when the grantor’s stock holdings are “significant from the viewpoint of voting control”; or a subordinate employee of a corporation in which the grantor is an executive.
21. Del. Code Ann. tit. 12, § 3580(10)(b)(3), (5); S.D. Codified Laws § 55-16-2(2)(c), (e). But see Alaska Stat. § 34.40.110(b)(3); Mo. Rev. Stat. § 456.5-505(3)(2)(b); Nev. Rev. Stat. § 166.040(1)(b); R.I. Gen. Laws § 189.23; Utah Code Ann. § 2-56-14(2)(c)(iv).
22. Tenn. Code Ann. § 66-1-202(a) (2006).
23. The author assumes that the 360-year period begins on the date the interest is created rather than on the death of a life in being at the interest’s creation, but the drafters did not so specify.
24. Investment Services Act § 14.
25. Again, this section of the Act is vague in that it does not specify whether the power of appointment must be over all trust property or just a portion.

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DARSI NEWMAN SIRKNEN is an associate with the Knoxville firm of Woolf, McClane, Bright, Allen & Carpenter PLLC. Her primary areas of practice include federal and state taxation, estate planning, and general corporate and transactional law. In 2006, she earned her law degree, with concentration in business transactions, from the University of Tennessee College of Law, graduating with highest honors and being named to the Order of the Coif. Sirknen is currently a degree candidate for a Master of Laws in Taxation from the University of Alabama. She can be reached via the firm’s Web site at www.wmbac.com.