Protecting assets is a major goal of estate planning, and as of March 2022, nineteen states have statutes that allow the creation of a domestic asset protection trust (DAPT). A DAPT is an irrevocable trust designed to protect trust assets from beneficiaries’ creditors. An even better version of this trust is the hybrid DAPT, which can offer another layer of protection for your client. Read on to learn how it works.
What Is a Hybrid DAPT?
A hybrid DAPT differs from a regular DAPT in that the settlor is not named as a trust beneficiary. Instead, the trust benefits the settlor’s spouse, descendants, or others. The fact that the settlor is not a beneficiary makes the hybrid DAPT a third-party trust. A trust protector may have the back-door option of naming the settlor as a beneficiary at a later date, but this is not ideal, as the DAPT would no longer fall into the “hybrid” category or retain its advantages.
Hybrid DAPTs are best established in states with a highly protective DAPT statute, like Nevada, South Dakota, Delaware, Alaska, and Tennessee. More than a dozen other states allow DAPTs, but practitioners generally consider these five states to have the best protection based on their statutes and established case law. For more information on states and their hybrid DAPT advantages, consult this chart.
This brings up the question of whether a hybrid DAPT can be set up in a state with a strong DAPT statute and not be subject to the laws of the client’s home state with a weak or no DAPT statute. In the last twenty years, this issue has not been successfully challenged in court, and creditors have chosen to settle out of court instead.
To establish a DAPT, at least one trustee must live in the state whose DAPT laws govern the trust. The settlor could be the investment trustee, while a resident of the state could serve as co-trustee. The settlor could also retain the power to remove and replace trustees.
How Can a Hybrid DAPT Meet Estate Planning Goals?
As its name states, a hybrid DAPT is established to protect assets for the trust beneficiaries. While planning for death taxes only applies to high net worth clients, asset protection is a key component of estate planning regardless of a client’s net worth. A hybrid DAPT shields assets from the settlor’s creditors by not including the settlor as a beneficiary and limiting the settlor’s retained powers over the trust. It can also be designed to keep assets from being accessed by the beneficiary’s creditors.
Another benefit of the hybrid DAPT is that it can help the settlor reduce, defer, or avoid taxes. Unless Congress takes further action, the current estate tax exemption of $12.06 million will sunset at the end of 2025. The amount will revert to the standard $5 million, which is expected to be adjusted for inflation to approximately $6.6 million. When the settlor makes a transfer that is a completed gift, the assets are removed from the settlor’s taxable estate, along with any appreciation. However, a completed gift means the settlor does not have power of appointment or veto power over distributions.
Download our sample DAPT to see drafting options within estate planning software, Wealth Docx
Income tax liability can also be affected by using a hybrid DAPT. Estate planners usually try to keep low-basis assets in the settlor’s estate rather than use them to fund a hybrid DAPT, so the assets will receive a step up in basis upon the client’s death. It would seem, then, that the goals of estate tax planning and asset protection may defeat the goals of income tax planning.
However, drafters can give a hybrid DAPT’s trust protector the power to grant a general power of appointment to beneficiaries. This gives the trust protector flexibility for dynamic income tax planning because it can be used to make low-basis assets includible in a beneficiary’s gross estate at death if income tax benefits outweigh other interests at that time.
Ideal Opportunities to Implement a Hybrid DAPT
A hybrid DAPT is best used for a client who has a solid marriage to a fellow American citizen. Hybrid DAPTs are particularly beneficial for clients who have high-risk professions, such as physicians and other healthcare providers. In addition, some clients who would be strong candidates for a spousal lifetime access trust may also benefit from a hybrid DAPT.
Prior to funding, the client should own the assets individually, as opposed to them being community or joint property. Ideally, the assets would be expected to appreciate, and they could be transferred irrevocably without negatively affecting the client’s standard of living. If the client does not need access to these assets for their remaining lifetime, the trust protector will not have to add the client as a beneficiary in the future. This will preserve the hybrid nature of the trust and its advantages.
However, if the settlor needs access to the hybrid trust assets, the trustee can make a distribution to the settlor’s spouse. A distribution to another beneficiary (or a spouse who is not a US citizen) who intends to share or give the distribution to the settlor may have gift-tax implications to the beneficiary. Alternatively, if asset protection becomes less of a concern, such as after the client retires from a high-risk profession, the trust protector could add the client as a beneficiary, but distributions through the spouse are still the best plan for the optimal benefits. Another option for the settlor to receive trust assets is through a loan secured by a promissory note.
Reaping the Benefits of a Hybrid DAPT
A hybrid DAPT can take advantage of the historically high gift tax exemption while using the settlor’s disposable assets. Drafting a hybrid DAPT properly can also provide flexibility for future income tax and estate planning purposes. To see how you can streamline the creation of DAPTs using the premier estate planning software, Wealth Docx, by downloading WealthCounsel’s sample DAPT, click here.