Offshore Trusts and Bankruptcy

Bankruptcy changes the analysis fundamentally. In ordinary creditor litigation, an offshore trust operates outside U.S. court reach because the foreign trustee is not subject to U.S. jurisdiction. In bankruptcy, the rules shift. The bankruptcy trustee has powers ordinary creditors lack, federal law overrides state exemptions and foreign trust protections in specific ways, and disclosure obligations are stricter. An offshore trust can still provide protection in bankruptcy, but 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. Added by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, this section allows a bankruptcy trustee to avoid any transfer made to a self-settled trust within ten years before the filing. The transfer must have been made with actual intent to hinder, delay, or defraud creditors.

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

An offshore trust funded three years ago may be effectively judgment-proof in ordinary litigation because the Cook Islands statute of limitations has expired. That same trust, if the settlor files for bankruptcy, can have its transfers challenged under the ten-year window. The offshore trust’s short limitation period 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 show that the specific transfer was made to hinder, delay, or defraud 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 lives 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 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 court reached the same result. 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 result 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 strips away the legal framework the trust was designed to operate within.

Disclosure Requirements

A debtor who files for bankruptcy must disclose all assets, including offshore trust assets, on the bankruptcy schedules. This is mandatory.

Failure to disclose constitutes concealment, which can lead to 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 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.

Disclosure 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 can be avoided under Section 548(e) or other provisions.

Bankruptcy Trustee Powers

A bankruptcy trustee has powers that ordinary judgment creditors lack. The trustee stands in the shoes of a hypothetical judicial lien creditor as of the filing date. The trustee can exercise the avoidance powers under Sections 544, 547, and 548 of the Bankruptcy Code and can compel turnover of estate property 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 court finds a transfer avoidable under Section 548(e), it 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. This parallels the contempt and repatriation issues 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 proceeds to creditors. If the trustee cannot reach offshore trust assets because the foreign trustee will not comply with U.S. orders, the trustee may abandon the attempt if pursuit costs exceed likely recovery. However, the trustee can seek denial of the debtor’s discharge if the debtor 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. This means the value of offshore trust assets may be included in what creditors are owed under the plan, even if the trustee cannot physically recover those assets. The result can be a repayment plan requiring substantially higher payments than the debtor anticipated.

When Bankruptcy Is Voluntary

Most asset protection planning assumes 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. The trust is designed to provide leverage outside the bankruptcy system.

The risk arises when bankruptcy is involuntary (creditors force it) or when the debtor’s financial situation deteriorates to where bankruptcy becomes the only option for unrelated reasons. 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 twelve or more exist). Proper planning can make involuntary petitions difficult to sustain. Structuring obligations so that twelve or more qualifying claims exist makes it procedurally harder for a single aggressive creditor to force a filing. Defending against involuntary bankruptcy is 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.

Offshore trust planning should be part of a comprehensive strategy rather than a standalone solution. Anyone who relies exclusively on an offshore trust without coordinating domestic exemptions, insurance, and entity planning may find that a bankruptcy filing exposes vulnerabilities that would not exist in ordinary litigation.

Practical Implications

Bankruptcy shapes offshore trust planning in several ways.

Timing matters more. The ten-year look-back means a trust funded five years ago is still within the avoidance window in bankruptcy, even though it would be beyond challenge in ordinary litigation. Anyone who funds an offshore trust should understand that full protection against bankruptcy avoidance requires funding more than ten years before any filing.

Voluntary bankruptcy should be avoided. Anyone with an offshore trust who files voluntarily invites scrutiny under the most unfavorable legal framework available. If financial distress arises, alternatives to bankruptcy should be explored first.

Disclosure is non-negotiable. The trust must appear on bankruptcy schedules, and all prior IRS filings must be consistent. A trust 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 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 mechanics of how offshore trusts work create a jurisdictional barrier that survives even in bankruptcy, and the fraudulent transfer analysis that applies outside bankruptcy provides the state-law foundation that Section 548(e) supplements. The broader offshore trust framework should account for bankruptcy risk from the outset.