The vital tax planning tool few advisors know
There’s an acronym few financial advisors are familiar with — but they absolutely should get to know.
DAPTs, the abbreviation for self-settled domestic asset protection trusts, can play an important role in planning for both income and estate taxes.
What is a DAPT? Unlike most other irrevocable trusts, which are third-party trusts (for example mom sets up a trust for her children), DAPTs are different because mom can also be a beneficiary. That flexibility offers potentially dramatic planning opportunities for clients.
Here’s the catch: DAPTs cannot be created everywhere. The laws of about 17 states permit them. The most popular of these states have been Delaware, Alaska, Nevada and South Dakota, although the laws of some more recent states may also be favorable. Because most states still do not permit DAPTs, the trusts must be created in one of these states using a trustee in that state. That trustee often is an institution.
Meanwhile, planners don’t need to worry that having an institutional trustee will interfere with their business relationship with their client. That’s because most DAPTs are directed trusts, meaning a person designated as the investment advisor directs the investment of the trust assets back to the same advisor who has served the client — the institutional trustee in the DAPT state does not have to manage investments (and many of them do not have that capability).
The uncertainty with DAPTs is whether a client in a non-DAPT state like New York can set up a DAPT in Nevada, and still have that trust respected. While a recent court case in Alaska has been interpreted by some to suggest that they cannot, the question is still disputed by commentators and it appears that DAPTs may still be viable for non-DAPT state residents.
Sometimes, crunching the numbers shows surprising results. Here’s how advisors can evaluate the tradeoffs of relocating to regions with lower taxes.
The new tax law poses a dilemma for wealth managers.
You could tell clients to move to another state to avoid a $1.2M tax bill. Or you could suggest a domestic asset protection trust instead.
Here’s an example to show how DAPTs can offer asset protection to a moderately wealthy client: Consider a scenario in which you have a physician client worth $4 million. She’s very worried about malpractice claims, so understandably, she wants to protect her assets now. That said, she may also need those funds for her post-retirement years. To accomplish both goals, she could gift $1 million of non-qualified plan savings into a trust that she’s a beneficiary of. She would arguably grow assets out of the reach of claimants, but still be able to access those assets when needed in retirement.
Meanwhile, the new tax law has also increased the allure of DAPTs. The new law temporarily doubled estate tax exemptions from $5 million to $11 million, adjusted for inflation. In 2026, the exemption drops back to the $5 million inflation adjusted figure. (And that presumes that a future administration in Washington won’t roll back the exemption sooner.)
So, while many clients simply want to ignore the estate tax as irrelevant, the growth in their wealth by 2026 may well put them over the estate tax threshold when the exemption is halved. What to do? Ultrahigh-net-worth clients can just gift the $11.18 million current exemption to a trust for heirs and use their exemption. But for most clients, that is not feasible as they will need access to the gifted money since the numbers are just so big relative to their wealth.
Consider an example where your client is worth $10 million. She wants to gift $6 million to use up some of her exemption now and grow wealth out of her estate in light of the future drop of the exemption and general uncertainty over future tax laws. But unless she has the ability to access the assets as they grow in that trust, a transfer of this size would not be acceptable to her. A DAPT provides the perfect solution because she can be a beneficiary of that trust, yet still have the assets grow outside her estate.
How to create a DAPT: If your client lives in a DAPT state just do the plan. These states include: Alaska, Delaware, Hawaii, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming.
If your client lives in a different state, then you have to set up a trust in one of the above states, but there are some additional complications and risks.
The Uniform Voidable Transfers Act indicates that a transfer to a self-settled DAPT is voidable if the transferor’s home state does not have DAPT legislation. This and a recent case in the Alaska Supreme Court suggest that for clients living in states not on the above list, the planning is riskier (but still possible).
A recent court case: The recent case is Tony 1 Trust v. Wacker (AK Sup Ct Mar. 2018). After both Montana and the U.S. Bankruptcy Courts entered default judgments on a lawsuit claiming that the transfers to an Alaska trust were fraudulent, the trustee brought an action in Alaska courts seeking a judgment that the decisions in Montana and the U.S. Bankruptcy Court were essentially void because an Alaska statute provides that any court proceeding relating to transfers to self-settled Alaska trusts must be determined exclusively by Alaska courts. The Alaska Supreme Court refused.
Some commentators have contended that the decision is the death knell for self-settled trusts created in any DAPT state by a resident of a non-DAPT state. But the truth appears far different. All that the Supreme Court of Alaska held was that Alaska could not require that any proceeding relating to the transfer of assets to an Alaska self-settled trust be before an Alaska court. It did not invalidate self-settled trusts created in that state. So, the game is on, just with caution.
How to do DAPTs better: There are a number of steps that can be taken to make a DAPT plan more secure, and financial advisors have a critical role in several of these, as well as informing clients of this planning option. There are also different approaches to structuring DAPTs that can make them safer. Here are a few:
- Have the client sign a solvency affidavit confirming that they have adequate resources after the transfer for all their future expenses. Better still, back this up with a current balance sheet and financial forecasts corroborating the assumptions.
- Don’t have the client listed as a current beneficiary of the trust. Rather, give someone acting in a non-fiduciary capacity (i.e., without the legal constraints of a fiduciary, like a trustee) empowered to appoint descendants of the client’s grandparents as additional beneficiaries. If the client needs the funds in the future, then the client can be added. Until added, the trust is not a DAPT, so even if the naysayers about DAPTs are right, the trust is not a DAPT until the client is added.
- Alternatively, give someone also in a non-fiduciary capacity the power to direct the trustee to make distributions to the client. In this way, the trust is arguably never a DAPT because the trustee never has the right to make distributions to the client creating the trust.
- Make loans instead of distributions to the settlor.
Why DAPTs remain vital to planners: Whether they’re used for estate tax planning or asset protection, DAPTs are an important tool for planners as they present a means for a client to secure assets from claimants and future estate taxes, while still offering the ability to access those assets.
If your client lives outside one of the states listed above, consider the use of some alternative structures and take additional precautions to make the DAPT plan more likely to succeed.