Complex Trusts Explained in Understandable Q&A: Dynasty, BDIT, IDIT DPAPT and More

By by Martin M. Shenkman, CPA, MBA, JD

Sophisticated Trusts in English:

DAPTs, BDITs, IDITs and More

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?
    1. 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).

    1. 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.

    1. 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.”

  1. What Would Motivate you to Consider a CGDAPTs?
    1. Asset protection.  If the trust is properly formed and administered, the assets transferred to the trust are not deemed to be a fraudulent conveyance, and the transferor does not file bankruptcy within 1 year of the transfer, the assets will have a measure of protection from claimants. State law will specify different time periods during which a claimant may attack a transfer.  Protection should be provided by using a DAPT because you, as the grantor/transferor, remain only a discretionary beneficiary of the independent trustee (e.g. a bank or trust company) of the trust.  It is difficult for a claimant to force an independent trustee to make a wholly discretionary distribution.
    2. Divorce protection.  It has become more common to establish DAPTs before marriage so that the assets are out of the marital estate prior to marriage.  While some will go so far as to use this in lieu of a prenuptial agreement, both measures of protection are advisable.  The concept is that if assets are transferred to an irrevocable trust before the marriage, it will be far more difficult for a later spouse to make a claim on those assets.  If you are not a trustee and only a discretionary beneficiary, in the decision of an independent, perhaps institutional trustee, then the protection should be greater.  Care must be taken as to how the trust is operated, including but not limited to how distributions are made, so as to not jeopardize this planning protection in the event of a divorce.
    3. Growth in the value of assets outside the transferor’s estate.  If a completed gift trust (CGDAPT, dynasty trust or BDIT) is used, the increase in the value of the assets transferred to the trust should be outside of your taxable estate.  If you sell assets to one of these completed gift trusts, the increase in the value of the assets over the note that the trust gives you to consummate the sale, should all be outside of your taxable estate.
    4. Lock in valuation discounts on the interests transferred to the trust.  Valuation discounts on the interests transferred to the trust should be locked in prior to Congress restricting or eliminating the discounts.  For example, if a limited liability company (“LLC”) owns real estate worth 2 million, 40% of the LLC would be worth $800,000.  However, an unrelated buyer would not be willing to pay $800,000 since 40% is a non-controlling position and the interest in the LLC could not be easily sold. Therefore, a discount for lack of control and lack of marketability could apply to the 40% interest.  It might be valued at only $600,000.  With this type of planning, $200,000 in value will arguably have inured to the trust from the initial transfer.  There have been a host of proposals in Congress to restrict, or even eliminate, these types of discounts, so there could be a substantial benefit to making transfers to trusts before the law changes.
    5. Tax burn.  Create a grantor trust (like the DAPT) in which income is earned inside the trust, growth occurs inside the trust, but the income tax on any income or gains is paid by you as the grantor/donor.  Each dollar of tax you pay on income retained inside the trust reduces assets remaining in your estate and facilitates a more rapid build up of value inside the trust.  This incremental build up should be outside your taxable estate and outside the reach of your creditors or malpractice claimants. Tax practitioners refer to this planning benefit as “tax burn.”
  2. What is the profile of someone who would be suitable for this planning?
    1. The profile of the different types of trusts is somewhat different.  But in every case, the terms of the trust, the assets transferred to the trust, the manner of the transfer or transfers of those assets, and ancillary planning, should all be tailored to your unique circumstances.  While every trust, even the commonly used insurance truest, should be tailored for each circumstance, these trusts are more complex.  The dollars involved are usually very substantial, and considerable customization in the documentation and planning is the norm.
    2. You may have sufficient wealth that you want to transfer significant assets to an irrevocable trust, but you have some concern that you may not have adequate assets, and in particular adequate liquid assets or cash flow to meet your needs in the event financial or other circumstances do not unfold as planned.  Since everyone’s perceptions of these risks and needs are so different, there is no rule of thumb as to what is required.  In very general terms, if your net worth is in a $3-$20+ million range, you might consider using a CGDAPT so that you can create growth outside your estate, while having some ability to benefit from the assets in trust. Perhaps at levels above this amount (but again, it is very subjective) you might be comfortable making gifts to a dynasty trust that you are not a beneficiary of.  Some people will employ a combination of both.  For married people that can take advantage of two $5 million exemptions, the range is likely higher.
    3. Other factors to consider are whether you live in a state that has decoupled from the federal estate tax system (about 20 have done so).  The state estate tax costs might motivate transfers to a CGDAPT, dynasty trust, sales to a BDIT, etc., at lower net worth levels than for those living in a state with no estate tax or which tracks the federal estate tax.  Caution should be exercised.  Several states have a gift tax, and even among the states that don’t have a gift tax, the manner in which they calculate the estate tax may incorporate, partially or fully, the impact of prior gifts.  In some states, there will be a significant state estate tax benefit from making a gift to a DAPT, you will still be able to benefit from those assets, and the value of the assets may, in part or whole, be removed from your estate for state estate tax purposes.
    4. Asset protection concerns worry (or should) anyone with wealth.  All of the trusts listed above, if properly implemented, should provide a measure of protection (but as with all of life, there are no guarantees).  Some practitioners argue that a BDIT is preferable, but not all agree.  The rationale for that position is that you did not form the trust (i.e., you were not the settlor/trustor) and, importantly, that you did not make any gratuitous transfers to the trust.  Any assets you transfer to the trust would be as a sale, at fair market value.
    5. You have to be sophisticated enough to deal with the complexities of the transaction and to work with appropriate professional advisers, or to entrust and authorize your advisers to address the complexities.  Without regular (at least annual) reviews, coordination of all advisers (accountant, estate planning attorney, corporate counsel, insurance consultant, wealth manager), these sophisticated plans will not likely succeed.
  3. What are the advantages of these trusts?
    1. Asset protection for all trusts.
    2. Estate tax benefits if a CGDAPT, dynasty trust or BDIT.
    3. Management, control and all the other benefits any well crafted trust plan can afford.
  4. What are some of the disadvantages of these trusts?
    1. Complexity.  Too many people get focused on simplicity as a goal, but if you’re embroiled in a messy divorce or other lawsuit, safeguarding your assets won’t be simple.  Also, if you are in the wealthiest 1% of the country, it is not reasonable or realistic to assume your goals and your wealth can be dealt with in the same manner as the average American. They cannot be.  But, as with all new things, the impediment initially is the unusual nature of the planning and the terminology.
    2. Need for regular administration.  These trusts and the related planning require ongoing care and maintenance, or they simply will not work.  At minimum, an annual meeting with all advisers is essential.  However, once the trust has been maintained for a year or two, other than a major new transaction, a routine will typically be created and the time and effort required for maintenance will decline.
    3. Less control.  But “control” is really a philosophical question and a problem for most people.  The fact that access to assets in the trust must be approved by an independent trustee, typically a financial institution, makes many people uncomfortable.  The reality is that the power to terminate and replace the institution is quite significant.  However, the real issue is that the perspective most people take is simply too narrow.  It is true that retaining unfettered “control” over assets will give you the unlimited right to their assets.  However, it also leaves those assets fully exposed to estate taxes, divorce and claimants.  That is hardly real “control.”
  5. What administrative burdens do you face?
    1. The integrity and independence of the trust and any LLCs, or other entities involved in the trust transactions, must be respected.
    2. Separate accounts must be established in the name of the trust and any ancillary entities.
    3. Income tax returns must be filed for the trusts and any ancillary entities.
    4. Gift tax returns must be filed to report most transfers.
    5. Annual meetings coordinating all advisers are essential.
    6. The operational provisions in the trust must be adhered to.
    7. There are typically several fiduciaries involved with these trusts and they have to appropriately handle their roles.
  6. What costs are likely to be incurred to set up a complex trust?
    1. There are costs for all of this, and they are not inexpensive.  But the costs have to be evaluated relative to the protection, estate tax savings, and other benefits.  In most cases, the costs are quite modest compared to the annual fee you pay a wealth manager for even one year of managing assets could be equal to assets that could be decimated by divorce, lawsuit or taxes.  The costs are often modest compared to malpractice and other insurance premiums.  The costs for a plan will vary considerably depending on the size, complexity, steps involved, need for appraisals, etc.
    2. Fees and costs are perhaps at least $10,000 at minimum, although a minimum is more likely $25,000+.  The costs can be dramatically greater depending on how complex the transaction, how many “bells and whistles,” and so forth.  The fees and costs for complex transactions can exceed $100,000.  It all really depends on your goals, the value and nature of assets involved, the complexity and number of appraisals, and so forth.
    3. Appraisal fees can be significant and can sometimes exceed legal and accounting fees.  There may be a requirement for two appraisals.  For example, if an LLC owns a building, an appraisal of the underlying building will be required.  If you transfer interests in the LLC owning the building to the trust, an appraisal of the LLC (which under current law will reflect discounts) will be required.
    4. Accounting fees for income and gift tax returns, projections and analysis to structure the deal, and other steps should be considered.
    5. Insurance costs should also be considered.  This might include liability coverage, insurance for trustees, etc.
    6. Corporate counsel may also be required to address the myriad of business/entity issues that may be involved.
    7. Real estate counsel may be required for real estate issues that may have to be addressed.  Bear in mind that real estate is perhaps never directly transferred to one of these trusts, but rather, transferred into an LLC that may in turn be transferred to the trust.

  7. Where these trusts should be established (trust situs).
    1. Most of these sophisticated domestic trusts are established in one of four states: Delaware, South Dakota, Nevada or Alaska.  A number of other states have also enacted laws that facilitate formation and operation of these types of trusts.
    2. Although other states have enacted similar laws, the significant majority of these types of trusts are formed in one of these four states.
  8. Who should be named a trustee of these trusts?
    1. To obtain situs (connection) to one of these states, if you do not reside in one of these states, an institutional trustee based in that state is often named as trustee.
    2. It is generally advisable to use an institutional trustee in one of the four states.  Not using an institutional trustee, in the view of many practitioners, substantially increases the tax and legal risks associated with these transactions.
    3. Naming a trustee in another state may expose the trust to state income taxes, or undermine the legal integrity and goals for the trust.
  9. Have asset protection trusts (APTs) been challenged?
    1. These trusts, and the various transactions that may be used to transfer assets to them, are not without risk, and have not been expressly upheld by any court.  The risk is likely greater if you live in a state that does not have laws favorable to these types of trusts, and have to have your trust set up in a state you otherwise have no connection to.
    2. In a recent case in Alaska, Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, May 26, 2011 (Original Memorandum) and July 18, 2011 (Memorandum Denying Motion for Reconsideration) permitted creditors to reach assets held in an Alaska asset protection trust.  However, most practitioners note that plan, design and administration of the trust was far from optimal.  Further, the person setting up the trust filed for bankruptcy, exposing the trust assets to bankruptcy rules.
    3. There have been several IRS rulings which lend some credence to various aspects of the techniques, but there really has been no specific case upholding or trouncing the techniques.  So, yes, there are risks, but there are certainly very substantial numbers of all these different types of trusts that have been created for the approximately 15 years these laws have permitted them, and there are many of these trusts still being created and significant assets transferred to them.  Years ago, there was a statistic that over $100 billion in assets had been transferred to these types of trusts domestically.

  10. Is there a risk another state or the federal government might not recognize a DAPT?
    1. There are a host of risks, some, but not all, of which have been discussed above.
    2. But what are the risks of doing nothing?
    3. Whatever the risks and whatever technique or type of trust used, proper and meticulous planning and administration, will lower the risks.
    4. Many estate planning practitioners believe that the various trusts above (not just APTs) used creatively, in the right manner, are perhaps the most powerful financial, tax, estate, asset protection and family planning technique available. The benefits can be tremendous.
    5. Remember Benjamin Franklin’s famous quip: "In this world nothing can be said to be certain, except death and taxes."

 

IRS Circular 230 Legend:  Any advice contained herein was not intended or written to be used and cannot be used, for the purpose of avoiding U.S. Federal, State, or Local tax penalties.  Unless otherwise specifically indicated herein, you should assume that any statement in this communication relating to any U.S. Federal, State, or Local tax matter was not written to support the promotion, marketing, or recommendation by any parties of the transaction(s) or material(s) addressed in this communication.  Anyone to whom this communication is not expressly addressed should seek advice based on their particular circumstances from their tax advisor.