Featured in the American Bar Association’s Real Property Trust & Estate Law June eReport today, was this article about the Hybrid Domestic Asset Protection Trust (also known as the “Hybrid DAPT”) authored by nationally renowned estate and asset protection planning attorney, Steven J. Oshins, J.D., AEP (Distinguished).

Background

Asset protection has become one of the hottest areas of law and has become the ideal complement to estate planning. Consequently, the Domestic Asset Protection Trust (“DAPT”) has become one of the most popular asset protection tools in the planner’s toolbox. As more states have enacted DAPT legislation, practitioners have started doing more DAPTs for their clients.

After approximately 16 years since the first DAPT legislation passed, no non-bankruptcy creditor has challenged a DAPT all the way through the court system and been able to access any DAPT assets. Most likely this is because such a large supermajority believes that if tested the DAPT will work to protect its assets from a creditor of the settlor. However, despite the very high likelihood of protection, if there is a way to increase the odds of success even more, then such a strategy should be utilized whenever possible.

The Hybrid Domestic Asset Protection Trust

The Hybrid Domestic Asset Protection Trust (“Hybrid DAPT”) is a strategy that should increase the probability that the trust assets will be protected. And it is very simple. The Hybrid DAPT is just like a regular DAPT except that the settlor isn’t an initial discretionary beneficiary of the trust, but can be added later. Thus, the trust is initially set up for the benefit of the settlor’s spouse and descendants, for example, but not for the settlor. By not including the settlor as a beneficiary of the trust, the Hybrid DAPT is by definition a third-party trust and therefore almost certainly avoids the potential risk of uncertainty of a regular DAPT. The Hybrid DAPT strategy can be used either with a completed gift or incomplete gift version of the DAPT technique.

Especially where the settlor is married and has a strong, trusting relationship with his or her spouse, is there any good reason that the settlor must have his or her name in the trust agreement as a beneficiary? It is very simple to indirectly access the trust assets through the spouse. And the trust agreement should define the “spouse” using a “floating spouse provision” that says that the spouse is the person the settlor is married to and living with from time to time. This gives the settlor the ability to access the trust assets through a subsequent spouse in the event of a divorce or the death of the settlor’s current spouse.

If the settlor has no spouse, then it becomes more difficult to access the assets. However, since a good asset protection planner will be sure to leave sufficient wealth outside of the client’s asset protection trust, in most cases the settlor won’t have to work through this issue anytime soon.

If the Settlor is added as a Beneficiary

In case the settlor needs to be a discretionary beneficiary of the Hybrid DAPT sometime in the future (i.e., if the settlor has no spouse or child that will “share” a distribution with the settlor and the settlor now needs a distribution), the trust agreement provides that the trust protector can add additional beneficiaries, including the settlor. However, if the settlor is added, then the Hybrid DAPT becomes a regular DAPT and thus risks that the law is still unsettled on DAPTs (even though most people believe that they work).

What happens if the settlor suspects that a creditor attack may be forthcoming? Or what if the settlor is considering filing bankruptcy? In either case, very far in advance of the problem occurring, the settlor would ask the trust protector to remove him or her as a discretionary beneficiary.

§548(e) of the 2005 Bankruptcy Act
It is extremely unlikely that a DAPT settlor will file for bankruptcy, especially if the settlor has an “old and cold” DAPT that is past the applicable state’s statute of limitations period. In fact, of the hundreds of DAPTs created by the author of this article, not one of those clients has gone through bankruptcy.

However, in maintaining the philosophy of this article that it is important to build into the structure every safeguard available, it is interesting to note that the Hybrid DAPT most likely does not fit the definition required by §548(e) of the 2005 Bankruptcy Act that would otherwise potentially claw back the assets of a traditional DAPT. The requirements of §548(e) are as follows:

(1) In addition to any transfer that the trustee may otherwise avoid, the trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if—

(A) such transfer was made to a self-settled trust or similar device;

(B) such transfer was by the debtor;

(C) the debtor is a beneficiary of such trust or similar device [emphasis added]; and

(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

Unless the settlor is added as a discretionary beneficiary of the Hybrid DAPT, Subsection (C) doesn’t apply. Also, arguably Subsection (A) doesn’t apply either since the Hybrid DAPT isn’t a “self-settled trust or similar device” at the time the provisions are applied.

The Completed Gift Hybrid DAPT

Many DAPTs are designed as Incomplete Gift DAPTs where the sole objective is asset protection. However, many DAPTs are designed as Completed Gift DAPTs where the settlor is a discretionary beneficiary of a trust designed with the following attributes:

(i) It’s a completed gift for gift tax purposes,
(ii) The settlor is a discretionary beneficiary,
(iii) The trust assets are protected from the settlor’s beneficiaries, and
(iv) The trust assets are outside of the settlor’s estate for estate tax purposes at the settlor’s death.

The Completed Gift DAPT strategy was approved by the Service in PLR 200944002 where a resident of a DAPT jurisdiction established the DAPT using the laws of that DAPT jurisdiction.

However, with respect to a resident of a non-DAPT jurisdiction, although most practitioners are comfortable that this strategy works, whether the trust assets are open to creditors of the settlor is still uncertain since it is unclear which state law will apply for creditor purposes. The DAPT will be includible in the settlor’s estate at death if the trust assets are open to the settlor’s creditors. If this were the case, this would occur under IRC §2036(a)(1) since the settlor would be treated as retaining the ability to run up creditor debts which can be paid out of the trust at the settlor’s death.

IRC § 2036(a)(1) provides that the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which the decedent has retained for life or for any period not ascertainable without reference to the decedent’s death or for any period that does not in fact end before death the possession or enjoyment of, or the right to the income from, the property.

The Completed Gift Hybrid DAPT reduces this risk significantly since the settlor isn’t a discretionary beneficiary of the trust and, thus, it isn’t a self-settled trust. In an ideal scenario, the settlor will never need to be added as a discretionary beneficiary by the trust protector. However, if the settlor does need to be added at a later date, since the Completed Gift Hybrid DAPT also gives the trust protector the power to remove beneficiaries, as long as the settlor is removed as a discretionary beneficiary more than three years prior to death, there is no estate tax inclusion since IRC §2035 (the three-year contemplation of death rule) won’t apply.

Down and Dirty

To this date, no non-bankruptcy creditor has challenged a DAPT all the way through the court system and been able to access any DAPT assets. Although the cases have settled or the creditors have decided not to sue, the estate or asset protection planner must still consider how to plan if the law does go the wrong way. Unfortunately, although there will ultimately be case law in a non-bankruptcy scenario, whether good or bad, unless the case law goes through the appeal process and is ultimately decided by the highest court, we still won’t have any certainty. So it is prudent to plan for this uncertainty.

If the settlor has set up a Hybrid DAPT, whether as an Incomplete Gift Hybrid DAPT or as a Completed Gift Hybrid DAPT, if the settlor wants to be sure to preserve a portion of the Hybrid DAPT’s assets if the settlor is being added in as a discretionary beneficiary, the trustee can split the Hybrid DAPT into two separate trusts and the trust protector can add the settlor as a discretionary beneficiary of only one of the two trusts so as not to taint the other trust.

For example, if there are $10 million of assets in the Hybrid DAPT, the trustee might divide the trust into two trusts – the “Clean Hybrid DAPT” which doesn’t include the settlor as a discretionary beneficiary and has $8 million of assets, and the “Dirty Hybrid DAPT” which includes the settlor as a discretionary beneficiary and has $2 million of assets. Thus, the risk has been transferred away from the Clean Hybrid DAPT to the Dirty Hybrid DAPT (which, again, should be protected, but is potentially being sacrificed in the interests of not tainting the assets in the Clean Hybrid DAPT). This is nothing more than a risk management decision.

Summary

It is imperative that the asset protection planner create a plan with the highest probability of success. In most cases, it is possible to significantly increase the protection by simply using a Hybrid DAPT rather than a traditional DAPT. This article describes this structure and also creates a further structure where the Hybrid DAPT can be divided into a Clean Hybrid DAPT and a Dirty Hybrid DAPT so that even if the Dirty Hybrid DAPT is unsuccessful, it doesn’t taint the Clean Hybrid DAPT.

Download Steve Oshins’ 4th Annual Domestic Asset Protection Trust State Rankings Chart

RELATED EDUCATION

If you are interested in more about this topic, we have a detailed 60-minute teleconference coming up on Tuesday, July 23rd at 9am Pacific (12pm Eastern) with speaker and author, Steve Oshins. For more information, click here.

ABOUT THE AUTHOR

Steve Oshins is a member of the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada. He is rated AV by the Martindale-Hubbell Law Directory and is listed in The Best Lawyers in America®. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011 and has been named one of the 24 “Elite Estate Planning Attorneys” by The Trust Advisor and one of the Top 100 Attorneys in Worth. He can be reached at 702-341-6000, ext. 2 or soshins@oshins.com. His law firm’s website is www.oshins.com.