For many wealthy people, protecting their estate from taxes (living and upon death) and creditors is of paramount importance. People in high-level positions, such as business executives, can easily become the target of litigation, whether in their personal or professional life.
While trusts have always been effective instruments for protecting against taxes and creditors, implementing a trust strategy usually results in the person losing control over their assets in the trust, as well as the ability to to receive financial benefits. However, 19 states now allow a particular type of trust, known as the Domestic Asset Protection Trust (or DAPT), which offers these protections without the well-known drawbacks.
Each state has its own unique approach to what qualifies as a DAPT within its jurisdiction, so it’s important to note that laws can vary widely from state to state. Here is an overview of how DAPTs work:
Qualify as a DAPT
Some features or provisions related to DAPTs are similar from state to state. The person who creates the trust – commonly known as the settlor – must follow specific steps to ensure that it is properly established. A particular trust document must be drafted and most states require that the trust contain certain key characteristics to qualify as a DAPT. It must be irrevocable, and it must have specific language regarding protection against creditors. In addition, it must be managed by a qualified trustee and must specify which state law controls the operation of the trust.
To be irrevocable, the trust must contain restrictive provisions regarding the settlor’s relationship with the trust. The key provision underlying the proof of this is that the settlor cannot unilaterally terminate the trust once it is created.
In addition, although a DAPT, by its legislative design, allows the settlor to receive income from the trust, it may only be able to receive it under certain limited conditions.
Protection against creditors
To effectively protect against creditors’ access to the trust, the trust must also contain restrictive language known as “spending” provisions. These conditions make it clear that the settlor does not own the assets of the trust, does not have unrestricted access to the assets of the trust, and is furthermore unable to pledge his interest to the trust. a creditor.
In addition, state laws generally treat creditors to whom the settlor had an obligation before the creation of the trust differently from creditors who arise after the creation of the trust. Some states require that a notice be sent to pre-trust creditors when the trust is created to inform them of a limited window to make claims before losing access to the trust’s assets. Creditors who present themselves after the creation of the trust are generally denied access to the assets of the trust.
It is important to note that many states allow certain creditors to access trust assets. Most of these creditors are linked to the public policy of supporting family obligations such as spousal support, alimony and child support. There are also guarantees in most states that will not prevent a creditor from accessing the assets of a DAPT if the transfer to the trust was made fraudulently.
Be a qualified trustee
To be a Qualified Trustee, the person must be a resident of the State. If the trustee is a corporation, the corporation must be a financial institution operating in the state. One of the most vulnerable areas for challenging a DAPT concerns the independence of the trustee. If there was an “informal” understanding between the trustee and the grantor regarding the grantor’s ability to continue to manage and access the assets of the trust, then the DAPT will easily fail if challenged. Further, if the settlor is able to exercise considerable influence over the trustee and the way the trustee fulfills his fiduciary duties, the trust may fail as a sham. Thus, it is important that the fiduciary relationship effectively withstand scrutiny in a legal challenge.
Fund a DAPT
A DAPT can be funded with traditional investments such as cash, stocks, bonds, and mutual funds. However, a licensor can also use more complex assets such as limited liability companies, business assets, intellectual property, or real estate to fund a DAPT. Before funding the DAPT, it is important that the grantor, usually working with trusted advisors, effectively assess all the assets at its disposal to determine which assets are best suited to enter the trust.
The IRS generally allows assets to be excluded from a DAPT for federal estate tax purposes. If it becomes clearer from the White House and Congress that the inheritance tax exemption will be lowered, it may be very important to have a trust that will not be included in the gross estate of the constituting on death to effectively eliminate or reduce taxes on death. However, in order for the trust to be excluded from the inclusion of federal estate tax, the language of the document and the relationship between the settlor and the trustee are usually well analyzed before making a final decision.
Additionally, a DAPT may offer income tax savings if the trust is legally established in a state without income tax. Thus, a DAPT can be an effective shelter against state income taxes for residents of states that impose income tax on its residents.
Make sure a DAPT is right for you
For a multitude of reasons, a DAPT can be a very useful vehicle for a wealthy person. As with most complex planning techniques, using a DAPT has its advantages and disadvantages. The appropriate process of establishing and administering the trust for the particular state in which the trust is located should be closely followed. Thus, it is important to hire the services of a lawyer or accountant who works in the field to ensure that a DAPT is suitable for your unique situation. He or she will be able to assess your unique situation and articulate your best options based on the assets you own, where you live and your financial goals.
Written by Chris Kelly, JD
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