Asset protection planning is a necessary subspecialty of estate planning. In fact, it is inconceivable that any estate planner would fail to have at least a basic understanding of asset protection strategies available to their clients.

There are generally two main options for domestic asset protection trusts: regular domestic asset protection trusts (DAPTs) and hybrid domestic asset protection trusts (hybrid DAPTs). This article explains why a hybrid DAPT is far superior to a regular DAPT for residents of states that do not have a DAPT statute or that have a weak DAPT statute.

Domestic Asset Protection Trusts

A regular DAPT is an irrevocable trust set up in one of the nineteen states that allow such a trust. It is not necessary for the person establishing and funding the trust (the settlor) to reside in one of those nineteen jurisdictions. Under the DAPT statutes of each of those jurisdictions, the assets transferred to the trust by the settlor should be protected from the settlor’s creditors after a certain waiting period.

There is no question that a DAPT provides asset protection for a resident of the DAPT state. The settlor is simply using their state’s statute to set up a protected trust. However, whether a DAPT provides asset protection for a resident of a non-DAPT state remains unsettled. A secondary and similar question is whether a resident of a state with a weak DAPT statute can successfully establish an asset protection trust under the laws of a state with a strong DAPT statute.

After more than two decades since the first DAPT legislation passed, no nonbankruptcy creditor has challenged a DAPT all the way through the court system and been able to access any DAPT assets by arguing that the court should apply local law rather than the law of the DAPT jurisdiction. This is probably because a large majority of creditors believe that if tested, a DAPT will protect its assets from a creditor of the settlor.

Despite the very high likelihood of protection, there are many people who do not think a DAPT will survive if challenged. In support of that belief, they refer to the dictum of In re Huber,[1] in which the court stated that local law would prevail. Many estate planners believe that the rationale underlying the statement was incorrect, but the opinion nevertheless exists and is therefore cited.

The good news is that for clients, a settlement is just as good as a victory in court. In fact, our clients want cheap and quick settlements of creditors’ claims. The lack of case law after the passage of so many years indicates that DAPTs have worked rather nicely because most creditors have been willing to enter into settlement agreements.

Nevertheless, the belief that DAPTs will not work for residents of non-DAPT states is sufficiently prevalent that attorneys must consider the possibility that the presiding judge will agree with such a belief.

Hybrid Domestic Asset Protection Trusts

The hybrid DAPT is a strategy that substantially increases the probability that trust assets will be protected. It is very simple: the hybrid DAPT is identical to a regular DAPT except that the settlor is not a beneficiary of the trust—although the settlor can later be added as a beneficiary. For example, the trust would be set up for the benefit of the settlor’s spouse and descendants, but not for the settlor. By not including the settlor as a beneficiary of the trust, the hybrid DAPT is by definition a third-party trust: therefore, it will almost certainly avoid the uncertainty and risk of scrutiny associated with a regular DAPT.

If the settlor is married and has a strong, trusting relationship with a spouse, is there any good reason for the settlor to be named as a trust beneficiary? It is very simple for the settlor to indirectly access the trust assets through the spouse. The trust agreement should define the settlor’s spouse using a floating spouse provision specifying that the spouse is the person to whom the settlor is married from time to time. This provision allows the settlor to access the trust assets through a subsequent spouse in the event of a remarriage after a divorce or the death of the settlor’s current spouse.

If the settlor has no spouse, it is more difficult for the settlor who is not also a beneficiary to access the trust assets. For the unmarried client, attorneys should advise clients to transfer less of their wealth into the trust and to consider setting up a limited liability company (LLC) to protect nontrust assets, taking advantage of the charging order protection generally available for LLCs. (A charging order is simply a lien.)

Good asset protection planners will be sure to leave sufficient wealth outside of the client’s asset protection trust. Nonetheless, if the need arises for the settlor to be a discretionary beneficiary of the hybrid DAPT at some point in the future (i.e., if the settlor has no spouse or child who will share a distribution with the settlor and the settlor needs a distribution), the trust agreement allows the trust protector to add beneficiaries, including the settlor. However, if the settlor is added, the hybrid DAPT becomes a regular DAPT subject to the risks associated with the unsettled state of the law on DAPTs.

Accessing the Assets of a Hybrid DAPT

There are many ways for the settlor to indirectly access the hybrid DAPT assets, so it is almost inconceivable that a settlor will ever be added as a beneficiary in most cases.

The most common means of access is through a distribution to the settlor’s spouse. The distribution trustee can simply give the investment trustee (generally the settlor) permission to make a distribution to the spouse. The spouse can then share the distributed cash with the settlor.

If the settlor is unmarried, or if the trust has two settlors because the trusts assets were transferred from the community property of the spouses (and therefore neither is a beneficiary), the distribution trustee can give permission for a distribution to be made to the settlor’s children, siblings, parents, boyfriend, girlfriend, best friend, or other trusted individual who can use it for the settlor’s benefit, for example, by paying the settlor’s credit card bills each month.

If the trust was designed as an incomplete gift trust for gift tax purposes, note that any transfers from the trust to someone other than the settlor or the settlor’s spouse in excess of the annual exclusion amount are completed and potentially taxable gifts. Further, any transfers back to the settlor from the donee are completed gifts. Most people’s estates are valued well below the estate and gift tax exemptions, so this generally is not a major concern. If the settlor is in need, tax ramifications are also less likely to be a consideration.

For an incomplete gift trust, another way to access the trust assets is for the settlor to exercise their lifetime power of appointment to appoint assets to the settlor’s spouse, children, siblings, parents, boyfriend, girlfriend, best friend, or other trusted individual who can use them for the benefit of the settlor.

A loan of cash from the trust to the settlor in exchange for a promissory note is another means by which a settlor can access the trust assets.

Hybrid DAPT Weaknesses

The hybrid DAPT has no weaknesses: it is simply a third-party trust that is, by definition, fully protected. The only scenario in which a potential weakness arises is if a trust protector adds the settlor as a beneficiary. However, if the estate planner makes good decisions about which assets to include and which should remain outside of the hybrid DAPT, this is unlikely to be necessary.

Obtaining Jurisdiction in a Strong DAPT State

It is important to establish the trust in one of the states with the most protective DAPT statutes. Typically, the settlor names a trust company in that state as a co-trustee unless the settlor has a friend or family member who is a resident of that state. The trust company generally acts as the distribution trustee and the settlor generally acts as the investment trustee, although alternative structures can be used. The settlor generally retains the power to fire and hire trustees, so the choice of trustee is not set in stone. The estate planner will guide the client to an appropriate trust company after factoring in the cost and cooperation of the trust company and the degree of protection offered by the DAPT state’s laws.

Choice of Law

A very substantial majority of estate planners establish DAPTs in Nevada, South Dakota, Delaware, or Alaska. I believe the best DAPT states are Nevada and South Dakota, with Tennessee close behind them. Delaware and Alaska are also good states for the establishment of DAPTs, although their laws are significantly less attractive than those of the leading DAPT states.

Summary

DAPTs are powerful and provide a high degree of asset protection. However, for a resident of a state without a DAPT statute or with a weak DAPT statute, no other asset protection mechanism is comparable to the hybrid DAPT. For top asset protection planners, the hybrid DAPT is arguably the go-to asset protection strategy for those clients. The foregoing is surely a controversial statement, but it should cause asset protection planners to stop and think about their probability of success and their goals—to insulate the trust assets as much as possible, thereby invoking the so-called fear factor to induce a favorable settlement or being able to walk into a courtroom without much concern. Hybrid DAPTs have transformed the asset protection industry. Over the years, asset protection planners have upped their game by using the hybrid DAPT as their go-to strategy for clients outside of states without strong DAPT statutes because of the substantially greater level of protection it provides for those clients over a regular DAPT.

^[1] 493 B.R. 798 (Bankr. W.D. Wash. 2013).