Self-settled trusts sound like estate planning nirvana to some, but as with all sophisticated planning tools, the devil is in the details.
Self-settled trusts are also known as domestic asset protection trusts. These are irrevocable trusts for which the same individual is both the person setting up the trust (the settlor) and also a discretionary beneficiary of the trust.
The estate planning magic of the technique is that if you can gift assets to this type of trust and remain a beneficiary, you may achieve the seemingly impossible goal of removing assets from your estate while still being able to benefit from them.
As with many sophisticated estate planning strategies, however, there are risks, complexities and lots of details that have to be tended to. There is also a lot of controversy over whether self-settled trusts are even viable.
YEAR-END GIFT CHALLENGE
In seeking to take advantage of the $5.12 million supersize gift exemption in 2011 and 2012, the biggest hurdle that many people faced was the fear that if they gave that much wealth to their heirs, they might run out of money themselves.
But if a wealthy client gives the gift to a self-settled trust, and not outright to heirs, he or she might accomplish both goals. The trust could name not only the client's children as beneficiaries but also the client's spouse or partner and all descendants, as well. Giving distributions to the spouse or partner could create more security.
These types of spousal/family trusts (sometimes called spousal lifetime access trusts) have become popular, but they do not offer enough security for many people. After all, the rate of divorce is high - and there is a risk that the spouse might die before the client.
But if the client can be a beneficiary too, it might create the security to really capitalize on the large gift exemption. So here's one simple truth about self-settled trusts: If your client is uncomfortable making a gift without being a beneficiary, there may be no other option.
SETTING THEM UP
The number of states permitting these trusts has grown to 14 since Alaska first allowed them nearly 15 years ago. But most are set up in four states: Alaska, Delaware, Nevada or South Dakota.
If a client lives in one of those 14 states, and the assets are located in any of the self-settled-trust states, your plan has a great likelihood of success.
But if the client lives in New York, which does not permit such trusts, and you establish a trust in Alaska, what happens if the client is sued in his or her home state?
The claimant will have to take the judgment to Alaska and seek to have it enforced. If Alaska says no, the claimant will have to appeal to the Supreme Court and argue that Alaska should recognize the judgment of the New York courts under Article IV, Section 1 of the Constitution, commonly referred to as the Full Faith and Credit Clause.
And since there are no cases addressing this issue, the reality is that no one can really say for sure what will happen.
If your focus is on reducing estate taxes, it may seem that you have little reason to care about creditor protection issues. But the ability of creditors to reach trust assets is also the litmus test for determining whether trust assets are included in an estate for estate-tax purposes. So for a self-settled trust's assets to be excluded from an estate, creditors cannot have had the ability to reach the assets in the trust.
If you set up a self-settled trust, the client cannot retain the right to amend or terminate the trust. He or she cannot retain the right to receive the income from it. The client's ability to receive distributions should only be at the discretion of an independent trustee (preferably an institutional trustee).
This should not cause trust assets to be included in the estate, so long as there is no understanding (the IRS often uses the phrase "implied agreement") as to what distributions the client may receive. If the receipt of distributions from the trust is no more than a mere "expectancy," it would appear that a creditor should not be able to reach the property -and that, by extension, the property should be out of the estate.