Offshore Trusts and Bankruptcy

Bankruptcy changes the asset protection analysis fundamentally. In ordinary creditor litigation, an offshore trust operates outside the reach of U.S. courts because the foreign trustee is not subject to U.S. jurisdiction. In bankruptcy, the analysis shifts. The bankruptcy trustee has powers that ordinary creditors do not, federal law overrides state exemptions and foreign trust protections in specific ways, and the disclosure and compliance obligations are more rigorous. An offshore trust can still provide protection in bankruptcy, but the rules are different and the risks are higher.

The 10-Year Look-Back

The most important provision for offshore trust planning in bankruptcy is Section 548(e) of the Bankruptcy Code. This section, added by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, allows a bankruptcy trustee to avoid any transfer made to a self-settled trust or similar device within ten years before the bankruptcy filing, if the transfer was made with actual intent to hinder, delay, or defraud creditors.

This is dramatically different from the fraudulent transfer rules that apply outside bankruptcy. In ordinary state-law litigation, the statute of limitations for fraudulent transfer claims is typically two to four years. In the Cook Islands, it is one to two years. Section 548(e) extends the look-back period to a full decade for transfers into self-settled trusts, which includes most offshore asset protection trusts where the settlor is also a beneficiary.

The practical consequence is significant. An offshore trust that has been funded for three years may be effectively judgment-proof in ordinary creditor litigation because the Cook Islands statute of limitations has expired. That same trust, if the settlor files for bankruptcy, can have its transfers challenged by the bankruptcy trustee under the ten-year window. The offshore trust’s short statute of limitations does not override federal bankruptcy law.

Section 548(e) requires the bankruptcy trustee to prove actual intent to defraud, not merely constructive fraud. The trustee cannot avoid a transfer simply because the debtor was insolvent at the time. The trustee must demonstrate that the specific transfer was made with the purpose of hindering, delaying, or defrauding creditors. This is a meaningful evidentiary burden, but it is applied under U.S. law by a U.S. bankruptcy court, not under Cook Islands law by a Cook Islands court.

Choice-of-Law Rejection

Outside bankruptcy, an offshore trust’s choice-of-law clause directs disputes to the trust jurisdiction’s legal framework. In bankruptcy, courts have repeatedly rejected these provisions when the debtor resides in a state that prohibits self-settled spendthrift trusts.

The analysis follows the Restatement (Second) of Conflict of Laws section 270, which examines the relationship between the trust and competing jurisdictions. When the settlor, the beneficiaries, and the creditors are all located in a single U.S. state, courts have found that the state’s interest in applying its own public policy outweighs the trust’s designation of foreign law.

In In re Portnoy (S.D.N.Y. 1996), the bankruptcy court applied New York law over a Jersey trust’s choice-of-law provision. The settlor was a New York resident whose only connection to Jersey was the trust itself. New York does not recognize self-settled spendthrift trusts, so the court included the trust assets in the bankruptcy estate. In In re Brooks (D. Conn. 1998), a Connecticut bankruptcy court reached the same result, applying Connecticut public policy to disregard an offshore trust’s foreign law designation. More recently, in U.S. v. Rogan (N.D. Ill. 2012), the court applied Illinois law instead of Bahamian law and ordered the debtor to turn over trust assets because Illinois does not protect self-settled trusts.

The practical consequence is that in bankruptcy, the offshore jurisdiction’s favorable statutes may not apply at all. The bankruptcy court can treat the trust as if it were governed by the debtor’s home-state law, which in most states means the self-settled trust provides no spendthrift protection. This does not eliminate the jurisdictional barrier that prevents the court from compelling a foreign trustee to act, but it removes the legal framework that the trust was designed to operate within.

Disclosure Requirements

A debtor who files for bankruptcy must disclose all assets, including assets held in offshore trusts, on the bankruptcy schedules. This is not optional and the consequences of nondisclosure are severe.

Failure to disclose offshore trust assets constitutes concealment of assets, which can result in denial of the bankruptcy discharge, dismissal of the case, and criminal prosecution for bankruptcy fraud. The bankruptcy trustee has broad investigative powers and access to financial records, tax returns (including Forms 3520 and 3520-A), and FBAR filings. An offshore trust that has been properly reported to the IRS throughout its existence will appear in the debtor’s tax records, and attempting to conceal it during bankruptcy is both futile and criminal.

The disclosure requirement does not mean the assets are automatically available to creditors. It means the bankruptcy trustee will know about them and will evaluate whether the transfers into the trust can be avoided under Section 548(e) or other provisions.

Bankruptcy Trustee Powers

A bankruptcy trustee has powers that ordinary judgment creditors do not. The trustee stands in the shoes of a hypothetical judicial lien creditor as of the filing date, can exercise the avoidance powers under Sections 544, 547, and 548 of the Bankruptcy Code, and can compel turnover of property of the estate under Section 542.

However, the bankruptcy trustee faces the same jurisdictional limitation as any U.S. party when it comes to assets held by a foreign trustee. The bankruptcy trustee cannot directly compel a Cook Islands trustee to turn over trust assets any more than an ordinary creditor can. The foreign trustee is not subject to U.S. bankruptcy court jurisdiction.

What the bankruptcy trustee can do is pursue the debtor personally. If the bankruptcy court determines that a transfer to the trust is avoidable under Section 548(e), the court can order the debtor to recover the assets. If the debtor cannot or will not comply, the trustee can ask the court to deny the discharge, hold the debtor in contempt, or impose other sanctions. The court makes those determinations, not the trustee, but the trustee drives the process. The analysis parallels the contempt and repatriation issues that arise in ordinary creditor litigation, but with the added consequence that the debtor’s discharge is at stake.

Chapter 7 vs. Chapter 13

In Chapter 7, the bankruptcy trustee liquidates the debtor’s non-exempt assets and distributes the proceeds to creditors. If the trustee cannot reach the offshore trust assets (because the foreign trustee will not comply with U.S. court orders), the trustee may abandon the attempt if the cost of pursuit exceeds the likely recovery. However, the trustee can seek denial of the debtor’s discharge if the debtor is found to have concealed assets or made avoidable transfers.

In Chapter 13, the debtor proposes a repayment plan. The debtor must pay creditors at least as much as they would receive in a Chapter 7 liquidation, which means the value of offshore trust assets may be included in the calculation of what creditors are owed under the plan, even if the trustee cannot physically recover those assets. This can result in a repayment plan that requires substantially higher payments than the debtor anticipated.

When Bankruptcy Is Voluntary

Most asset protection planning assumes that bankruptcy is something to avoid, not something the debtor will choose. A debtor who has established an offshore trust to protect assets from a specific creditor typically has no reason to file for bankruptcy. The trust is designed to provide leverage outside the bankruptcy system.

The risk arises when bankruptcy is involuntary (creditors force the debtor into bankruptcy) or when the debtor’s financial situation deteriorates to the point where bankruptcy becomes the only option for reasons unrelated to the trust. In either scenario, the debtor enters a system that is less favorable to offshore trusts than ordinary state court litigation.

Involuntary bankruptcy requires either a single creditor with an undisputed claim (if the debtor has fewer than twelve qualifying creditors) or three creditors acting together (if the debtor has twelve or more). Proper planning can make involuntary petitions difficult to sustain. Structuring the debtor’s obligations so that twelve or more qualifying claims exist makes it procedurally harder for a single aggressive creditor to force a bankruptcy filing. The mechanics of defending against involuntary bankruptcy are a core part of any offshore trust plan because keeping the debtor out of bankruptcy court is the single most important step in preserving the trust’s effectiveness.

This is one reason that offshore trust planning should be part of a comprehensive asset protection strategy rather than a standalone solution. Clients who rely exclusively on an offshore trust without coordinating with domestic exemptions, insurance, and entity planning may find that a bankruptcy filing exposes vulnerabilities that would not exist in ordinary litigation.

Practical Implications

For clients considering an offshore trust, the bankruptcy implications shape the planning in several ways.

Timing matters more. The ten-year look-back means that a trust funded five years ago is still within the avoidance window in bankruptcy, even though it would be beyond challenge in ordinary litigation. Clients who fund an offshore trust should understand that full protection against bankruptcy trustee avoidance requires the trust to have been funded for more than ten years.

Voluntary bankruptcy should be avoided. A client with an offshore trust who files for bankruptcy voluntarily is inviting scrutiny of the trust under the most unfavorable legal framework available. If financial distress arises, alternatives to bankruptcy should be explored before filing.

Disclosure is non-negotiable. The trust must be disclosed on bankruptcy schedules, and all prior IRS filings must be consistent with the disclosure. A trust that has been properly reported throughout its existence is in a far better position than one that was concealed or inconsistently reported.

The trust still provides value even in bankruptcy. Even if the bankruptcy trustee identifies the trust and attempts to avoid transfers under Section 548(e), the foreign trustee is not obligated to comply with U.S. court orders. The practical difficulty of recovering assets from an offshore jurisdiction still applies, and this difficulty affects the bankruptcy trustee’s cost-benefit analysis just as it affects any other creditor’s.

The how offshore trusts work article explains the core mechanics, the fraudulent transfer analysis covers the state-law framework that Section 548(e) supplements, and the offshore trust overview provides the broader evaluation framework.