By Martin M. Shenkman, CPA, PFS, AEP, MBA, JD
Planning with sophisticated trusts has burgeoned as taxpayers become fearful of the uncertainty about the future of the tax system (e.g., the drop in the gift and estate exemption in 2013 to $1 million and an increase in the rate to 55%). In the current estate tax environment, more people then ever may benefit from using a Domestic Asset Protection Trust or “DAPT”, but to understand this technique, and whether it, or a different approach would be viable for you, an understandable overview of DAPT and related planning options is needed. The following questions and answers are organized from a non-estate planner’s perspective to make them more accessible. Hopefully, this approach will help you better understand some of the great planning options that now exist, and that might be advantageous for you to consider, before the opportunities are legislated away.
1. What are the Key Features/Types of Trusts Typically Considered?
- Types of Trusts.
i. APT = Asset Protection Trust. An APT is not done for estate tax minimization. Assets transferred are done to remove the assets from the reach of creditors, but you as the grantor/transferor retains powers, which causes the assets to remain included in your estate.
ii. DAPT = Domestic Asset Protection Trust. A DAPT is an APT formed in the United States, rather than overseas.
iii. CGDAPT = Completed Gift DAPT. A CGDAPT an asset protection trust that is structured so that the transfers to it are completed gifts for gift tax purposes. Thus, the growth in value of assets occurs outside of your estate (in contrast to the APT, above).
iv. Dynasty Trust. Dynasty trusts are primarily established for estate tax planning purposes. They can be used for asset protection benefits, but the key distinction between a dynasty trust and a CGDAPT is that the grantor/transferor does not remain a beneficiary of the dynasty trust. Dynasty trusts are always set up as completed gift trusts and, ideally, are all set up to maximize the generation skipping transfer (GST) tax benefits. If you might need access to your assets, a DAPT or CGDAPT, not a dynasty trust, might be preferable.
v. BDIT = Beneficiary Defective Irrevocable Trust. A BDIT is similar to a CGDAPT, but the grantor/transferor forming the trust and transferring $5,000 of assets into it is typically a parent or other benefactor of yours. You would be given a right to withdraw (called a Crummey power) the $5,000, which you may choose not to exercise. This mechanism makes the trust a grantor trust as to you, which means that the income of the trust is taxed to you, even though you did not form or fund the trust. You can then sell assets to a trust for a note, and the growth in those assets should occur within the trust, while you pay the income tax on the earnings and gains of the trust. This payment of income taxes, while at first impression seems odd, is a power planning tool to further reduce your taxable estate (see discussion below). - Trust Characteristics.
i. Directed Trust. With a directed trust, instead of the trustee making investment decisions, which has been the historic norm, a person, perhaps called a “trust investment adviser” or “investment trustee”, determines which assets the trust shall hold as investments. If an independent or institutional trustee serves, if state law permits, they will not face liability for investment performance. This mechanism makes it feasible for a trust with an institutional trustee to hold interests in a closely held business and, therefore, charge lower fees commensurate with this reduced risk.
ii. Grantor Trust. The income and gains of a grantor trust are reported by the grantor (except for the BDIT, discussed further below). Importantly, you, as the grantor, may also sell highly appreciated assets to the trust without recognizing gain if the trust is characterized, for income tax purposes, as a grantor trust.
iii. Reciprocal Trusts – If two people, typically a husband and wife, create identical trusts for each other, the IRS may “uncross” the trusts and treat them as if each person created a trust for themselves. This would undermine any hoped for tax benefits, and could potentially jeopardize asset protection benefits as well. When multiple trusts are planned, steps can be taken to minimize this risk. - Combinations. It is common to use a combination of the above in creating an estate plan. For example, the husband might set up a dynasty trust that benefits the wife and descendants, and the wife might set up a CGDAPT that benefits herself, the husband and all descendants. This approach has become more common as clients seek to take advantage of the current $5 million gift exemption before Congress reduces its largess. The reason different types of trusts are used is that if a husband sets up a trust for the benefit of wife (and descendants) and the wife in turn sets up a mirror image trust for the husband, the IRS could “uncross” the two trusts and treat it as if each had set up a trust for themselves, thereby undermining any intended benefits. This is referred to as the “reciprocal trust doctrine.”