Until the late 1990s, spendthrift protection did not extend to trusts established by an individual for their own benefit (a self-settled trust). The assets inside would still be reachable by their creditors. Many states have since enacted Domestic Asset Protection Trust (DAPT) laws extending spendthrift protection to self-settled trusts so long as the requirements of the state-specific statute are met. While initially intended to achieve asset protection goals, the new creditor protection afforded to DAPTs inadvertently created incredible estate tax and income tax planning opportunities for individuals who do not wish to completely part with their assets.
A completed-gift non-grantor DAPT (CGNG DAPT) is a technique designed for those who have significant wealth and income. They are typically structured for the benefit of the grantor, the grantor’s spouse and the grantor’s descendants and sitused in a tax-friendly DAPT jurisdiction (e.g., South Dakota, Nevada, Delaware) by naming an in-state “directed trustee.” This type of trust mitigates both estate tax and income tax liability while maintaining indirect access to the trust assets if the need arises.
Estate and Gift Tax
A CGNG DAPT is structured so that transfers to the trust are completed gifts notwithstanding that the grantor is also a beneficiary of the trust. Such transfers consume the grantor’s estate and gift tax lifetime exemption, thereby removing the assets, income and appreciation from the grantor’s taxable estate. This makes a CGNG DAPT particularly attractive for those who wish to take advantage of the temporarily increased lifetime exemption before it sunsets in 2026.
The pitfalls of IRC § 2036 that would ordinarily bring assets of a self-settled trust back into the grantor’s estate are avoided through the DAPT’s unique creditor protection as well as vesting distributions in an independent trustee’s sole discretion.
Income Tax
A CGNG DAPT is also structured so that income and gains are taxable to the trust itself (a non-grantor trust) rather than to the grantor individually (a grantor trust). Great care must be taken in drafting the trust to avoid triggering one of the grantor trust rules. For example, distributions to the grantor or the grantor’s spouse must require the consent of another beneficiary (an adverse party) or the trust would be a grantor trust under IRC § 677(a)(1).
Like an individual, a non-grantor trust must pay federal income tax as well as state income tax in the state where it resides. However, a trust can “reside” in a state other than where its grantor does. In that way, a trust can avail itself of the laws of a DAPT state with no state-level income tax, which is especially beneficial to grantors who reside in high-income-tax states.
Nevertheless, the tax laws of the grantor’s home state are still relevant and must be carefully navigated. For example, both New Jersey and New York take the position that a non-grantor trust established by a resident would be subject to state income tax unless all of the following conditions exist:
- There are no in-state trustees.
- The trust does not own any tangible property located in the state.
- The trust has no income sourced to the state.
Moreover, New York and California have both enacted versions of a “throwback tax” which imposes a tax on undistributed income earned in prior years that is subsequently distributed to a beneficiary residing in the state.
Practical Considerations
There are several issues both clients and advisors should be aware of. First, receiving distributions from a CGNG DAPT is counterproductive from an estate tax perspective as the trust assets are already removed from the grantor’s estate. Thus, clients should not gift away assets, or the income from which, they need to spend in the future.
Second, there should be no expectation or implied understanding that the assets will be returned to the grantor in the future. Trust assets should only be consumed as a last resort in the trustee’s discretion.
Finally, for New Jersey and New York resident trusts, it is vital to ensure there is no state source income. While certain measures can be taken to segregate source income, poor drafting or inattention to trust investments could result in a single dollar of source income tainting the trust and subjecting all income to state income tax.