Use of Asset Protection Trusts for Estate Tax Planning Purposes

“Use of Asset Protection Trusts for Estate Tax Planning Purposes,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is ACTEC Fellow Connie Eyster of Boulder, Colorado.

Domestic asset protection trusts, currently permitted by state statute in 20 states, allow individuals the opportunity to protect assets from future creditors through the use of irrevocable trusts in which the grantor has retained some beneficial interest. What we commonly call asset protection trusts, however, can be used not only for creditor protection, but also as a vehicle for estate tax planning.

ACTEC Fellow Daniel Rubin of New York City joins us today to discuss the ways in which we can reimagine the planning opportunities available using asset protection trusts. Welcome, Daniel. Thanks for coming today.

Daniel S. Rubin: Thank you, Connie, for that introduction and hello to our listeners today. First off, I’d like to say that I’m a big fan of the ACTEC podcast series and I’m pleased to have this opportunity to present on what I believe to be an important and sometimes misunderstood topic.

Overview of Asset Protection Trusts

The trusts that I’m going to be speaking about today are often referred to as asset protection trusts because absent avoidable transactions in connection with the funding of the trust or a claim by a so-called exception creditor, such trusts are asset protective, notwithstanding the fact that the settlor has retained for himself a discretionary beneficial interest under the trust agreement.

However, such trusts are today more often used for the purpose of estate tax savings than for pure asset protection. When these trusts are used for the purpose of estate tax savings, I prefer to call them self-settled spendthrift trusts rather than asset protection trusts in order to reference the purpose for which the trust was created to negate any suggestion that the settlor had an intent to hinder, delay, or fraud, any creditor in connection with this planning. It remains important, however, to understand first how these trusts work for asset protection purposes so that we can then understand how they work for estate tax planning purposes.

Historically, a trust established by an individual for his or her own benefit has been fully available to his or her creditors, including creditors that didn’t exist as of the date of the creation of the trust and including creditors which were completely outside of the contemplation of the settlor of the date of the creation of the trust. Creditors that I commonly call “mere potential future creditors.”

But beginning in 1997, new laws began to be enacted in various forward-thinking states, which serve to allow a person to be both the settlor and the discretionary beneficiary of his or her trust. And if done properly under the given statute, the assets in the trust should be shielded from the claims of the settlor’s future creditors. Today, there are 20 states that have enacted this legislation.

When these trusts are established solely for asset protection purposes, and not for the purpose of estate tax savings, the trust is structured so as to render gifts to the trust incomplete for gift tax purposes. And this is accomplished through a reservation by the settlor a right to veto the trustee’s exercise of the trustee’s discretionary distribution authority, and through a reservation by the settlor of a testamentary power appointment, which together served to reserve in the settlor level of dominion and control as would render gifts to the trust by the settlor incomplete for gift tax purposes under Treasury Regulation 25.2511-2(b). Of course, the same dominion and control will cause estate tax inclusion when the settlor dies but again, the purpose of this variant of this self-settled trust is asset protection, and not estate tax planning.

Self-settled Trusts for Estate Planning Purposes

In contrast, when a self-settled trust is for estate tax planning purposes, the trust would instead need to be structured so as to render gifts to the trust complete for gift tax purposes. Thus, the settlor would not reserve for himself a veto power and not reserve for himself a testamentary power of appointment, however, even with a completed gift we still need to concern ourselves with the possibility of estate inclusion under Section 2036 and Section 2038 when the settlor ultimately dies.

Now there’s no question that if the settlor creates a trust under which the settlor retains the right to mandatory distributions, the trust property will be brought back into the settlor’s estate under Section 2036(a)(1) has a retained right to the possession or enjoyment or the right to the income from the property. And in most jurisdictions still, Section 2036(a)(1) will also apply to cause an estate inclusion even where the settlor’s beneficial interest is wholly within the discretion of one or more trustees because of the historic rule where a person creates a trust for his own benefit, his creditors can reach the maximum amount which his trustees can pay to him or apply for his benefit.

The Intersection of Asset Protection and Estate Taxation

And here’s the intersection between asset protection and estate taxation because if a settlor’s creditors can reach the settlor’s interest in the trust, the settlor will be deemed to have retained an indirect right to the possession or enjoyment of or the right to the income from the transferred property, causing inclusion under Section 2036(a)(1) as well as an indirect retained right to revoke or terminate the trust, causing inclusion under Section 2038.

The idea here is that where the trust is available to the settlor’s creditors, the settlor has retained the economic benefit of the trust property because the settlor can borrow money and then relegate his creditors to the trust fund for repayment. Conversely, where the settlor’s creditors cannot reach the trust assets, the settlor’s transfer of property to the trust has consistently been found to be complete for gift tax purposes.

In Private Letter Ruling 9837007, the IRS agreed that a gift to a self-settled trust established under Alaska law after the enactment of the Alaska Trust Act was, in fact, a completed gift, notwithstanding that the settlor was himself a discretionary beneficiary of the trust. But the IRS did not rule in that Private Letter Ruling as to whether the trust’s assets would be includable in the settlor’s gross estate for federal estate tax purposes when the grantor settlor died. In fact, we had to wait until 2009 for the IRS to issue a ruling with that conclusion.

Specifically, in Private Letter Ruling 200944002, the IRS ruled that the Trustee’s discretionary authority to distribute income and principal to the settlor did not by itself cause the trust corpus to be includable in the grantor’s gross estate under Section 2036. But the IRS was careful to note we are specifically not ruling on whether the Trustee’s discretion to distribute income and principal of the trust to the grantor, combined with other facts, such as, but not limited to, an understanding or pre-existing arrangement between the grantor the Trustee regarding the exercise of this discretion, may cause inclusion, which of course is a position that the IRS has long held.

For example, in Revenue Ruling 2004-64, which considered situations in which the settlor might be reimbursed for the income tax he pays by reason of having established a grantor trust, the IRS ruled that if the Trustee merely has the discretion to reimburse the settlor, rather than a mandate to do so, the existence of that discretion by itself, whether or not exercised, will not cause estate inclusion. But such discretion combined with other facts, including but not limited to, an understanding or pre-existing arrangement between the settlor and the trustee regarding the trustee’s exercise of this discretion, may cause an inclusion of the trust’s assets in the settlor’s gross estate for federal estate tax purposes.

I think it’s also important to make specific note of the fact that this is not an issue unique to self-settled trusts, but rather that this issue of an implied agreement exists with regard to all trusts, including third-party trusts, such as a trust that one might establish for one’s spouse, or a trust that one might establish for one’s children. Treasure Regulations Section 20.2036-1(c), which applies to all trusts and not just self-settled trusts, provides that for Section 2036 purposes, an interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, expressed or implied, that the interest or right would later be conferred.

So, how concerned should we be about the finding of an implied agreement? Personally, I don’t think that we should be particularly concerned. Clearly, if the trustee were to make regular distributions of the settlor, there could be an argument that the regular distributions, evidence and understanding between the settlor the trustee which could cause estate inclusion. But why would a person set up a trust if he’s going to diminish the tax planning benefits through regular distributions?

When we set up a SLAT, do we typically counsel clients that the spouse should be getting regular distributions, or do we typically counsel that access to the trust should be considered only as a last resort and only if there are no other funds available to maintain the family’s lifestyle? Of course, we counsel the latter. And, on this point, if there are no other funds available to maintain the family’s lifestyle, whether with regard to a SLAT or with regard to a self-settled spendthrift trust, I would suggest that the potential for estate inclusion by reason of a finding of an implied agreement is not in the least a significant consideration for what is now your literally poor client.

Considerations When Structuring and Administering Self-Settled Trusts

In any event, in order to avoid even the potential for the finding of an implied agreement, I would suggest the following in connection with the structure and administration of the self-settled spendthrift trust.

• First, have the settlor retain sufficient assets in his individual name to support himself for life after accounting for his other income and resources.
• Second, use a corporate trustee rather than an individual trustee. And as much as it would seem much less likely that an implied agreement can be found between the settlor and a corporate trustee, then would be the case where the trustee is the settlor’s brother-in-law, best friend, or professional advisor.
• Third, consider substitution of the original trustee for a successor trustee prior to any distribution being made, since it would seem to negate the possibility of an understanding of the time of the original transfer.
• And finally, and in a similar vein, consider a partial decanting into a new trust a different corporate trustee so that distributions might be made out of the new trust rather than from what remains in the original trust, thereby leaving the original trust free of any suggestion of the existence of an implied agreement.

Takeaways

In conclusion, let me state that I appreciate that some attorneys are not as yet completely comfortable with the use of these trusts for estate tax planning purposes, but I would suggest that for certain client populations, these trusts meet a need that could not otherwise be met, especially in light of the impending sunset of the bonus exemption at the end of next year (2025).

For example, the wealthy client who’s currently unmarried and who currently has no children, and who would simply just not engage in estate tax planning if he, himself, could not be a beneficiary of his own trust, or a married client who is concerned about divorce and for whom a SLAT is simply not an appropriate approach or a married client who is concerned about his spouse’s premature death and losing access to the substantial amount of wealth that would have been placed in trust for the spouse’s benefit. And finally, a married client who is not himself a US citizen and who therefore, cannot receive unlimited tax-free gifts from the spouse would be a beneficiary of a SLAT.

So, Connie, with those relatively brief thoughts on the use of self-settled trusts for estate tax planning purposes, as well as for asset protection purposes, I hope that I’ve given our listener some food for thought, perhaps a further opportunity to help our clients and their families.

Connie Eyster: Thank you, Daniel, for that really thorough analysis and interesting insight into the use of self-settled asset protection trusts. We so appreciate you joining us today, and we hope that you come back soon.

 

Additional Resources:

• An Update on Asset Protection Cases Where Lawyers Overstepped Their Boundaries (Jun 2022)
• How to Protect Inherited Assets from a Beneficiary’s Creditors in the Event of a Divorce (Jan 2021)
• Update of Asset Protection Trust Litigation (Dec 2019)
• Twenty Years of Domestic Asset Protection Trusts in the United States (Mar 2018)

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