Ins and Outs of Domestic Asset Protection Trusts (DAPTs)

(Image credit: Getty Images)

published 21 May 2024

Editor’s note: This is part five of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.

Almost 20 U.S. states now permit a person to set up an irrevocable trust that names themself as beneficiary even while the trust maker is alive, a type of irrevocable trust known as a domestic asset protection trust, DAPT or self-settled trust.

DAPTs are a dramatic departure from previous irrevocable trusts, which only permitted the trust maker to protect the trust property for someone else other than the trust maker themself. However, state lawmakers grew tired of seeing their constituents form trusts and transfer assets overseas so that the trust maker could achieve asset protection for themselves. Consequently, in 1997 lawmakers in some states (beginning with Alaska) decided to permit “self-settled” trusts, in which the trust maker could set up an irrevocable trust that protected assets for the trust maker themself.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just ~~$107.88~~ $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

https://cdn.mos.cms.futurecdn.net/flexiimages/y99mlvgqmn1763972420.png

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

In the most basic form, the principle behind an irrevocable DAPT is that a person cannot be sued for property that they don’t own. If a person irrevocably transfers their property into a properly designed and implemented DAPT, the property cannot be taken away by a creditor or a taxation authority because the irrevocable trust maker no longer owns the property — unless a court decides that the formalities of the DAPT are not being respected so the irrevocable trust maker really does own or control the trust’s property. It is also important to note that a court in a state that does not permit self-settled DAPTs may not respect the rules of the DAPT.

For both asset protection and tax planning purposes, an irrevocable trust maker must decide on many important trust features concerning how much possession and enjoyment they will retain over the trust, as well as how much control they will retain over the trust assets, such as serving as a manager over a rental property or business owned by the trust. Fundamentally, when the trust maker retains more control over the property transferred into the trust, the trust maker achieves less asset protection and less estate tax planning.

The most direct and obvious “possession and enjoyment,” as well as “control,” of an irrevocable trust is to retain beneficiary rights to distributions out of a trust and remain as a trustee. Currently, 17 states permit asset protection through DAPTs by meeting several important statutory requirements and restrictions.

DAPTs can’t protect assets from known creditors

Due to state and federal transfer laws, the amount of assets transferred into a DAPT must not leave the trust maker unable to pay off known debts and creditors, as well as potential creditors, such as those related to threatened or pending litigation. In other words, transfers into an irrevocable DAPT are a decision that must be based on an assessment, or liquidity analysis, that considers the amount of assets that the trust maker must keep in their personal possession so that they can satisfy potential creditors.

Example. The trust maker is the defendant in litigation over a business partnership gone wrong, and the trust maker believes they will lose to the former business partner. The trust maker quickly sets up an irrevocable DAPT and transfers assets into the trust. The trust maker later loses the litigation, and the judge issues a judgment and charging order (litigation lien) in favor of the former business partner and against the trust maker. Once the former business partner forecloses on the charging order and becomes the judgment creditor against the trust maker, the former partner attempts to collect against the trust maker’s property. However, the trust maker argues that they no longer own anything because they transferred the property into a DAPT. The former business partner files a motion to enforce the judgment, and in the hearing, the trust maker tells the judge that they cannot turn over property to the former business partner because the trust maker no longer owns the property. The judge reviews the transfer and determines that the trust maker violated the fraudulent-transfer laws by transferring the property in the face of litigation for purposes of hindering, delaying and defrauding a creditor and the court. The judge orders the trust maker to distribute the property back out of the trust immediately to satisfy the judgment, or the trust maker will be held in contempt of court.

As with transferring into any LLC or irrevocable trust, the transfer into a DAPT cannot leave the transferor unable to satisfy the DAPT trust maker’s known or threatened creditors.

The DAPT statutes in many states also require that the trust maker go even further and sign an affidavit of solvency or attestation. Some states, such as Wyoming, even require that the trust maker maintain at least $1 million in umbrella liability insurance.

Anytime a trust maker transfers additional assets into a DAPT, the trust maker must again conduct a liquidity analysis and sign a new attestation or affidavit of solvency. Additionally, a trust maker may need to report the transfers on a gift tax return if the transfers exceed the annual exclusion from reporting gifts into an irrevocable trust. Put differently, it is best to fund an irrevocable trust that is a DAPT in big enough tranches to make it worth the effort.

Forming DAPTs for out-of-state residents

A resident of a state that doesn’t statutorily permit DAPTs can still set up a DAPT by forming a trust which, in the trust formation documents, specifically invokes the statute of a state that does permit DAPTs. A DAPT can even be formed by a person who is the resident of a state that doesn’t permit DAPTs. To use the authorizing statute of a state permitting DAPT trusts, the distribution trustee must reside in the state whose law the DAPT utilizes. The asset protection of a DAPT is also increased if the DAPT holds and manages trust assets in the state where the DAPT is statutorily formed, though the asset location is only one more of the factors that increase the asset protection value of a DAPT.

The magic ingredient that permits a person to set up a DAPT to protect their own assets is a “distribution trustee,” a neutral, unrelated person who can decide whether to make a distribution to the trust beneficiary (in this case, a distribution to the trust maker). The distribution trustee must make the decision to distribute or not distribute the trust assets based on the trust’s provisions concerning distributions.

Typically, an irrevocable DAPT will provide that no distributions can be made to satisfy the debts of the beneficiary acquired after the formation of the trust, even if the beneficiary is the trust maker. Consider the following example of a DAPT distribution trustee refusing to distribute DAPT assets to the creditor of the DAPT beneficiary:

Example: The trust maker desires to protect their property against personal claims, so they properly form an irrevocable DAPT in a jurisdiction where a DAPT is permitted. The trust document appoints a distribution trustee who is authorized to distribute to the trust maker as the DAPT beneficiary, but the distribution trustee must not distribute to the trust maker’s creditors. Later, the trust maker is sued personally by an angry investment deal partner, and the trust maker’s angry partner wins the case against the trust maker. As judgment creditor to the trust maker, the angry partner sends a demand for payment to the DAPT distribution trustee, who refuses to pay under the terms of the trust. Because the DAPT was properly formed under a state statute permitting DAPTs, the investor is protected.

Where the DAPT is set up has an impact

DAPTs are most effective at protecting property located inside of the state where the DAPT is set up, and it is more difficult (though not impossible) to protect property (especially real estate) located in a jurisdiction that doesn’t statutorily permit a DAPT. This is because a court will want to set aside the DAPT and exercise quasi in rem jurisdiction over any real estate located in a state that refuses to recognize a DAPT.

However, most of the time, a properly structured DAPT can effectively protect assets and permit the trust maker to remain the DAPT trust beneficiary. Distributions to the beneficiary of the DAPT for any other purpose are usually permitted. Consider the following example of a DAPT trust maker requesting a proper distribution of DAPT trust property to themself as beneficiary of the DAPT:

Example: A trust maker with a DAPT properly formed in a state permitting DAPTs wants to rent out a cruise ship and take their friends to the Mediterranean on the trip of a lifetime. The trust maker is a management trustee over the DAPT, so the trust maker has authority to sell the DAPT assets. The proceeds from the sold DAPT assets are deposited as cash into the DAPT’s bank account, requiring countersignature from the DAPT distribution trustee so that the trust maker can use the cash to hire a cruise ship. However, the DAPT distribution trustee thinks that hiring a cruise ship is a terrible idea and refuses to distribute the cash to the trust maker as beneficiary of the trust. The DAPT trust maker emails the trust protector over the DAPT, and the trust protector investigates the distribution trustee’s actions. The trust protector finds that the beneficiary’s request is not contrary to the terms of the DAPT. So, the trust protector terminates the distribution trustee and appoints a new distribution trustee, giving the new distribution trustee instructions to make the distribution of money to the DAPT beneficiary. The DAPT beneficiary (also the trust maker) uses the cash from the DAPT to hire a cruise ship, and, together with their family and friends, the DAPT beneficiary has the time of their life.

DAPT structure affects estate tax

Although a properly structured and managed DAPT can provide asset protection through state authorizing statutes, it is not automatic that the federal government will permit the DAPT trust maker to exclude the assets from federal estate tax inclusion. Again, the amount of possession, enjoyment and control over the DAPT assets retained by the trust maker is a key determinant in whether the federal government will include assets in the trust maker’s gross estate.

However, the statutory features of DAPTs can be used to shore up the tax planning hoped for by other types of irrevocable trust tax planning, such as securing the now very popular spousal lifetime access trust (SLAT) against a claim that the SLATs were reciprocal, a common-law legal theory used by the IRS as a trust-killer.

As with any irrevocable trust, control over the trust property is key, and distributions to the trust maker of a DAPT must be under the control of a distribution trustee. As with any irrevocable trust, the degree of asset protection from a DAPT is on a sliding scale between good, better and best. If a trust maker needs to retain rights over managing the DAPT trust property, the trust maker achieves good asset protection, though not the strongest asset protection afforded by a DAPT.

To increase the asset protection from a DAPT, the trust maker can consider gradually relinquishing their rights and duties to serve as the manager trustee. To further fortify the asset protection from the DAPT, and even exempt the DAPT property from estate taxes, the trust maker might even later disclaim their rights as beneficiary of the irrevocable trust.

However, the trust maker must be aware of the capital gains tax sequelae that follows from disclaiming beneficial rights. In some cases, protecting an asset and removing it from the irrevocable trust maker’s gross estate creates collateral damage in the form of a negative capital gains tax impact.

Irrevocable trusts, including irrevocable DAPTs, can be configured to provide a spectrum of asset protection and tax planning benefits, depending on the degree of control, possession and enjoyment that the irrevocable trust maker retains.

My next article will go into how surrendering more control over a trust provides more asset protection.