Many advisors assume that domestic asset protection trusts (DAPTs) — self-settled trusts established in the United States typically to protect trust assets from a beneficiary's creditors — are created exclusively for high-risk professionals, such as physicians, who are exposed to potential financial ruin by malpractice judgments in excess of insurance coverage. Not so.
Many types of clients can benefit from a DAPT. Some advisors recognize this, but still fail to realize the full potential of this strategy.
It's time all practitioners be made aware that DAPTs are extremely flexible vehicles that can be used for a variety of clients for very different purposes. Structured properly, DAPTs can even help a client receive more favorable tax treatment. Currently, eight jurisdictions allow for DAPTs: Alaska, Delaware, Rhode Island, Nevada, Utah, Oklahoma, Missouri and South Dakota.
There are at least six unexpected scenarios in which a DAPT can help. But note: To date, there have been no reported challenges to the effectiveness of a DAPT in any U.S. court. And not every technique may be utilized in the states that allow for DAPTs, so advisors should carefully review a particular jurisdiction's statute before considering the following applications:
- For corporate officers and directors
Corporate officers and directors of publicly traded companies whose activities are under increased scrutiny may consider establishing an asset protection trust to protect some of their assets against potential claims. Specifically, by combining the concept of a “blind” trust (a trust in which a beneficiary doesn't know about the trust's specific assets and a fiduciary has complete management discretion) with an asset protection trust, officers and directors can relatively easily comply with security law restrictions, protect assets, and retain the ability to utilize those assets in the future.
- For entrepreneurs
Those considering entering into a high-risk business venture often move some of their net worth into a DAPT. This protects some of their assets against potential liability arising from high-risk business ventures before entering into them. Furthermore, entrepreneurs who spend years building a business and eventually sell it may be concerned about potential liability from purchasers or others. In fact, following a liquidity event, many entrepreneurs take a portion of the post-sale proceeds and place them in a DAPT.
- For vulnerable people
The elderly, the disabled and young adults who are or may become mentally, physically or financially impaired may consider establishing a DAPT to avoid assets being diminished against their will.
- For gifts/inheritances/marital estate
Particularly for those in high-risk professions or business ventures, individuals who receive gifts or inheritances may want protection against future creditor claims. Similarly, those contemplating marriage who are uncomfortable with pre-nuptial agreements or the disclosure requirements necessary to provide effective protection may establish DAPTs to protect against claims of potential ex-spouses.
- For trusts vulnerable to creditors
Certain estate-planning techniques, such as charitable remainder trusts, grantor retained trusts and Crummey trusts, are self-settled and potentially vulnerable to creditor claims. Similarly, trusts created by courts from personal injury awards are often self-settled and therefore subject to creditor claims if the trust is not created in a DAPT jurisdiction. Therefore, advisors who work with the recipients of personal injury awards should attempt to educate the judges to establish these trusts in a DAPT jurisdiction. Furthermore, recipients of personal injury and wrongful death settlements that are not placed in a court-created trusts may utilize DAPTs to protect their assets from family and non-family members. This is particularly useful for clients with long-term health issues who require the expenditure of funds throughout their lifetime.
- For retirement accounts
Unlike 401(k) plans, an Individual Retirement Account (IRA) doesn't offer creditor protection under the federal Employee Retirement Income Security Act of 1974 (ERISA). As a result, any creditor protection for an IRA comes from the state law under which it is established. So an IRA established as a DAPT with an anti-alienation provision, created under and subject to the laws of a state that's a DAPT jurisdiction, may be a more effective tool to protect the IRA assets from a creditor's reach.
DAPTs may be structured to create some interesting tax-planning opportunities. While asset protection trusts generally are tax-neutral and don't typically provide any special tax benefit or incentive, through careful drafting it's possible to get certain federal and state tax treatments. This flexibility adds to a DAPT's attractiveness.
- Income tax savings
One of the most innovative uses for DAPTs is to create a trust that reduces or eliminates state income and/or capital gains tax. Specifically, several DAPT states don't impose state income tax on trusts created by clients who do not reside in the DAPT jurisdiction. Furthermore, a client may be able to establish a DAPT that is designed as a non-grantor/incomplete gift trust and is not considered a taxpayer in the grantor's state of residence, thereby exempting the assets transferred to the trust from that state tax.
- Federal estate tax planning (gift trust)
Clients may want to reduce the size of their estate through gifting, but are concerned about losing the ability to retain an interest in the gifted assets. If a client establishes a DAPT that's structured as a completed gift (for federal transfer tax purposes), this would remove the gifted asset from the client's federal gross estate while allowing him to retain an interest to get back the assets in the event that they are needed.
- State inheritance tax avoidance
There's an additional incentive to creating a gift trust: Clients who reside in states that have state death taxes can avoid state inheritance taxes too. Specifically, most states that impose death taxes do not have a gift tax system that is unified with the death tax. This means that assets gifted during lifetime will not be taxed under the state death tax system. Therefore, by making a gift into the trust, a client may avoid state death taxes on the transferred assets while retaining the possibility of getting the funds back in the event it is needed.
- Grantor trust status
In Revenue Ruling 2004-64, the Internal Revenue Service concluded that the inclusion of a provision granting a trustee discretionary authority to reimburse a grantor income taxes attributable to the grantor trust doesn't cause inclusion under Internal Revenue Code Section 2036. Notwithstanding this revenue ruling, it's possible that state law would authorize a creditor to attach trust assets by including such a provision, which, in turn could cause inclusion under IRC Section 2036. In DAPT jurisdictions, however, it's clear that this type of creditor attachment is not possible. Clients therefore should consider establishing completed gift/grantor trusts in a DAPT jurisdiction to avoid this potential issue.
- Pre-immigration planning
Nonresident aliens may create trusts with intangible property free of gift and generation skipping transfer tax. Accordingly, before immigrating, such individuals may establish DAPTs to remove assets from their estates, but retain the ability to get the funds back in the event it is needed.
Jurisdictions that permit the establishment of DAPTs typically have additional substantive innovations that make these trusts an attractive alternative to foreign trusts.
- For foreign nationals
Wealthy foreign nationals utilize trusts to achieve a variety of results, such as tax savings and avoiding forced heirship laws. Historically, such individuals would rarely consider a U.S. situs trust. However, due to certain federal tax law changes (lower tax rates coupled with greater flexibility regarding foreign trust status) coupled with the substantive innovations in certain DAPT jurisdictions, particularly Alaska, Delaware, Nevada and South Dakota, it is attractive to foreign nationals to create these trusts in DAPT jurisdictions. In fact, these innovations (such as dynasty provisions and the ability to use outside investment and distribution advisors), along with the asset protection advantages, may make a DAPT jurisdiction like Alaska, Delaware, Nevada and South Dakota a preferred jurisdiction for foreign nationals to create trusts
- For domestication of offshore trusts
Many of the offshore advantages that kept assets in foreign jurisdictions can now be addressed through DAPTs. Specifically, asset protection, dynasty provisions and greater management flexibility make a DAPT an attractive alternative to establishing or continuing a foreign situs trust. Therefore, as DAPTs are viewed as attractive alternatives to foreign trusts, it is possible, if not probable, that a trend towards domestication of these offshore trusts will continue.
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