Asset protection is becoming a more import-ant part of many estate plans, and a domestic asset protection trust (DAPT) is the strategy of choice in more and more plans.
A DAPT can help achieve several estate planning goals.Of course, the prime reason to consider a DAPT is to protect assets from potential creditors, including potential adversaries in lawsuits.
A DAPT also can exclude assets from the taxable estate, reducing lifetime estate and gift taxes. State income taxes also might be reduced by using a DAPT. I
n a typical DAPT, you are the grantor, or creator, of the trust and have the trust agreement drafted. The agreement names you as one of the permissible beneficiaries.
It also should name other beneficiaries, such as your spouse and children. Then, you transfer assets to the trust. This is known as a self-settled trust, since you are grantor of the trust, a beneficiary and transferred assets to it.
Normally, assets in a self-settled trust are not protected from creditors of the grantor. A DAPT is different. About 20 states have enacted DAPT laws that ensure assets in the trusts are protected from creditors of the grantor when certain conditions are met.
The trust must be irrevocable. There are no conditions under which you can demand the return of the assets or terminate the trust.
In addition, the trustee must be an independent third party. You or a member of your family can’t be trustee or a co-trustee. The trust will have a spendthrift provision, which means the trustee controls the distribution of assets.
There are no automatic distributions, and the beneficiaries and any creditors of the beneficiaries can’t demand distributions or cause them to be made.Also, the trust must have substantial relationships with the state whose DAPT law you’re relying on (the DAPT state).
The DAPT is unlikely to be effective if you live in a state other than the DAPT state and use a trustee who isn’t located in the DAPT state. Most DAPT laws require that at least one trustee be a resident of the DAPT state. Some also require the trust to use a financial institution in the state.The best candidates for DAPTs are those in occupations that are at high risk for liability lawsuits, such as doctors and lawyers.
Anyone with a relatively high net worth, high profile or risky life-style also might be a target for liability lawsuits and should consider a DAPT.
People who use a lot of leverage in their businesses or who own businesses that are at high risk of failure also might want to shelter some of their assets from potential creditors in DAPTs.
There are two other important conditions to creating an effective DAPT.
The first condition is you must retain enough assets outside the DAPT to maintain your lifestyle. A good attorney won’t set up a DAPT until there’s been an analysis of the client’s lifestyle and future spending needs. Then, assets must be set aside outside the DAPT that are estimated to be adequate to fund that lifestyle over a reasonable life expectancy.
The reason for this is that for the DAPT to be effective, distributions to beneficiaries should be infrequent. If the grantor-beneficiary is receiving regular distributions to pay for living expenses, courts are likely to ignore the DAPT when considering creditors’ claims. The trustee will have discretion over when distributions are made and to whom they’ll be made.
A DAPT won’t be effective if the trustee is required to make regular distributions to you or other beneficiaries. You need enough assets outside the DAPT to fund your lifestyle.
The second condition is that you can’t be under imminent threat of being sued or being pursued by creditors. Transfer–ring assets to a trust or another person or entity when you’re under threat of losing them is a fraudulent conveyance. The law will ignore the transfer and treat you as owner of the assets.
In addition, state DAPT laws have waiting periods. The creditor protection doesn’t take effect until the waiting period is over.
The waiting period varies from state to state but is two years or longer.Most states also have creditors who are excepted from the asset protection of the DAPT. Alimony and child support are common exceptions, and some states have additional exceptions. Nevada is the only state whose DAPT law has no excepted creditors.
Though not required, it is best that the trust have more than one beneficiary.
Courts are more likely to view the trust as a ruse to avoid creditor claims when you created the trust and are the only beneficiary. Not all types of assets can be protect-ed by a DAPT, especially if the DAPT is formed under the law of a state other than the one in which you reside.Cash and marketable securities are the best assets to contribute to a DAPT.
The cash easily can be held in a financial institution that’s based in the DAPT state. Some attorneys recommend for an additional layer of protection that a limited liability company (LLC) be formed in the DAPT state.
The LLC owns the marketable securities, and ownership of the LLC is transferred to the DAPT.
Real estate and small businesses are more problematic.Courts generally hold that they have jurisdiction over real estate located in their states. Real estate is most likely to be protected when it is located in the DAPT state and owned through an LLC formed under that state’s law.Small business assets and interests in small businesses can be owned through LLCs, and the LLC ownership interests can be contributed to the DAPT.
But it’s not clear how well the business assets will be protected, especially when the business isn’t located in the DAPT state. You might own other assets that are at risk of generating lawsuits, such as jet skis, boats, motorcycles, trailers, motor homes and aircraft.
You might obtain extra lawsuit protection by having a separate LLC own each asset, and then contributing the LLC ownership interests to the DAPT. This is another strategy whose effectiveness is unknown at this point.
DAPTs were created in response to increased use of foreign asset-protection trusts (FAPTs) by U.S. citizens.
A DAPT should be less expen-sive and more convenient to set up and maintain than a FAPT. But a DAPT might not offer as much protection as a FAPT.
DAPTs are relatively new and haven’t been tested often in the courts. In addition, U.S. courts are required to recognize judgments of courts in other states, and the trustee must follow court orders.
If you’re resident in or do business in a state other than the DAPT state, a court in your state might choose to ignore the DAPT law and rule in favor of your creditors.Most estate planning attorneys who advise on asset protection say the real advantage of a DAPT or a FAPT is that it creates hurdles and additional costs for potential creditors.
The creditors are more likely to drop questionable legal actions and settle other actions when they learn a lot of your assets are in a DAPT that has been set up carefully.