Since July 9, 1997, when Governor Thomas R. Carper signed Delaware’s Qualified Dispositions in Trust Act (“Delaware Act”), Delaware and non-Delaware residents have been using the Delaware Act to save taxes, to protect assets, and to accomplish other purposes summarized below. This article highlights key features of this kind of trust.
Under the common-law rule against self-settled trusts, an individual traditionally could not create a self-settled trust (that is, an irrevocable trust from which he or she could benefit) and protect trust assets from claims by his or her creditors. So, if a client created an irrevocable trust and gave the trustee discretion to use the income and principal for the client and his or her spouse and children, the client’s creditors could reach all trust assets, even if the trust had a spendthrift clause.
As American society became increasingly litigious, interest developed in a trust in which the person creating the trust could retain some potential benefits that could not be reached by his or her creditors. Until 1997, this interest was satisfied only by a trust, often called an “asset- protection trust” (APT), created in a foreign jurisdiction.
The Delaware Act, 12 Del. Code §§ 3570–3576, gave birth to the Delaware APT. Besides Delaware, the states that now have some form of APT law are Alaska, Colorado, Hawaii, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, and Wyoming. New Delaware APTs are signed regularly.
The Delaware APT is not for every client. Instead, it is an option to consider along with other techniques for shielding assets, such as liability insurance, incorporation, tenancy-by-the-entireties property, homestead exemption, retirement plans, and IRAs.
Benefits of Delaware APTS
A trust that is structured as a Delaware APT can provide several benefits.
Employ Tax Benefits. A client might be reluctant to give away assets to use part or all of his $5.45 million gift-tax exemption (and a deceased spouse’s unused exemption) for fear that he will need the funds in later life. Although the tax treatment is less certain than for an outright gift or a gift to a third-party trust, the client should consider using a Delaware APT for these tax benefits because he may be a discretionary beneficiary of the trust and could get assets back in an emergency.
Reduce Federal Transfer Tax. A client will save federal transfer tax if he makes a gift that incurs gift tax, if he lives at least three years after making the gift, and if his estate must pay estate tax. If a client makes the gift through a Delaware APT, he might be able to get funds back from the trust if needed.
Avoid State Death Tax. If a client’s state of residence imposes an estate or inheritance tax, he might be able to reduce that tax by making a gift before death. If the client makes the gift to a Delaware APT, he potentially could get funds back in the event of need.
Assure Favorable Tax Treatment for Grantor Trusts. A client’s payment of income taxes attributable to a grantor trust is not a taxable gift, and inclusion in a grantor trust of a provision that gives the trustee discretion to reimburse the client for such taxes will not cause the trust to be included in the client’s gross estate, provided that, as is true under the Delaware Act, the client’s creditors may not reach trust assets by reason of the inclusion of that discretion. Rev. Rul. 2004-64.
Avoid State Income Tax. A client might try to use a type of Delaware APT commonly known as a “Delaware Incomplete Nongrantor Trust” (DING Trust) to avoid income tax on undistributed ordinary income and capital gains of a trust imposed by a state that has not adopted the federal grantor-trust rules (that is, Pennsylvania). Also, the IRS has ruled several times that APTs may be nongrantor trusts if they are structured so that distributions to the grantor are controlled by adverse parties. See, e.g., PLR 201510001. Consequently, a client might be able to avoid state tax on undistributed ordinary income and capital gains of a trust imposed by one of the 43 states that follow the federal grantor-trust rules. As a nongrantor trust for state tax purposes, the client’s home state may not tax the trust because of a lack of contacts with the trust and Delaware would not impose a tax on income accumulated for non-Delaware beneficiaries. In later years, a client possibly could receive tax-free distributions of the untaxed income.
Effective in 2014, this option is not available in New York.
Obtain Asset Protection
General. Through success in business, savvy investing, or the receipt of a gift, inheritance, or personal-injury award, a client might own substantial assets outright. He could fund a Delaware APT with some of those assets to get protection from future creditor claims and business reverses.
Protect Young Adults’ Assets. A client should encourage his or her children to put assets that they receive (or may withdraw from a trust) at majority in a Delaware APT. Although the children can receive distributions from the trust, they will not have the unlimited ability to squander them.
Provide Pre-Marital Planning. Because Delaware APTs are immune from claims by future spouses, a client’s children can use them to shield assets from those claims without providing the financial disclosure that is required to implement effective pre-nuptial agreements.
Protect Vulnerable Persons. If a client is mentally, physically, or financially vulnerable, he should consider using a Delaware APT to protect assets.
Protect Estate-Planning Vehicles
Several common estate-planning vehicles, such as CRTs, GRATs, and QPRTs, are self-settled trusts and therefore are vulnerable to creditor claims. In fact, two courts have included the debtor’s interest in a CRT in the bankruptcy estate, In re Mack, 269 B.R. 392 (Bankr. D. Minn. 2001); Mennotte v. Brown, 303 F.3d 1261 (11th Cir. 2002), and two other courts have included the debtor’s interest in a QPRT in the bankruptcy estate. In re Earle, 307 B.R. 276 (Bankr. S.D. Ala. 2002); In re Ferrante, Nos. CC-14-1222-KiTaPa, CC-14-1223-KiTaPa, 2015 Bankr. LEXIS 2854 (BAP 9th Cir. Aug. 26, 2015). The Delaware Act extends protection to these arrangements.
Provide Options for NRAs
If a client is a nonresident alien (NRA), he should consider a Delaware APT for two purposes. First, a Delaware APT is a viable estate-planning and asset-protection option for an NRA, whether or not he has family members in this country. Second, if a client is considering immigrating to the United States, he might want to create a Delaware APT to take advantage of the favorable tax treatment afforded lifetime gifts by NRAs before immigration and to keep the ability to get funds back if needed.
Provide Protection for Existing Trusts
If a client has created a self-settled trust in a state where it does not have protection from creditors, he should explore moving it to Delaware. Similarly, for a number of reasons, a client might want to relocate a foreign APT to Delaware.
How to Create a Delaware APT (12 Del. Code §§ 3570(8), (11), 3571)
To create a Delaware APT, a client must establish an irrevocable trust that contains a spendthrift clause, designates Delaware law to govern the trust, and appoints at least one “qualified trustee.” A “qualified trustee” is an individual who lives in Delaware (except the client) or a Delaware trust company that performs certain duties. The trust may have non-Delaware co-trustees and Delaware or non-Delaware advisers.
The Delaware Act specifically permits a client to have the power to
- • consent to or direct investment changes,
- • veto distributions,
- • replace trustees or advisers, and
- • effective in 2015, reacquire trust assets in a nonfiduciary capacity.
The Delaware Act also expressly authorizes a client to have one or more of the following:
- • the ability to receive income or principal under broad discretion or a standard,
- • the right to receive current income distributions,
- • an interest in a CRT, GRAT, or QPRT,
- • up to a 5% interest in a total-return unitrust,
- • a lifetime or testamentary power to appoint the principal in the trust to or for anyone except the client, the client’s estate, the client’s creditors, or the creditors of the client’s estate,
- • the ability to be reimbursed for income taxes attributable to the trust on a mandatory or discretionary basis, or
- • the power to provide for the payment of taxes, debts, and expenses payable at the client’s death.
Under the Delaware Act, any “understanding” that a client will receive money whenever he asks is void.
A Delaware APT can be funded with tenancy-by-the-entireties property without destroying protection from each spouse’s separate creditors.
Because not specifically permitted by the Delaware Act, a Delaware APT should not
- • appoint the client trustee or co-trustee,
- • provide that the client will get trust assets back at a certain age or after a certain amount of time,
- • authorize the trustee, adviser, protector, or committee to terminate the trust, or
- • authorize the trustee to reimburse the client for gift taxes.
Although permitted by the Delaware Act, a Delaware APT should not, in certain circumstances
- • appoint a co-trustee in the state where the client lives or works or
- • give the client the power to replace the trustee.
A client should fund a Delaware APT with assets that he never expects to need. A rule of thumb for avoiding a fraudulent transfer is to fund a Delaware APT with one-third to one-half of a client’s surplus assets that are not already exempt from creditor claims after he performs an analysis of existing and foreseeable assets and liabilities.
The best assets to put in a Delaware APT are cash, stocks, and bonds.
Interests in an FLP or LLC are good assets to put into a Delaware APT, provided that the client is not the general partner or a manager and that the entity does not own real estate outside Delaware.
Non-Delaware Real Estate
A client should not put real estate outside Delaware in a Delaware APT because it will give non-Delaware courts jurisdiction over the trust and a basis for applying non-Delaware law.
Putting non-Delaware real estate in an FLP or LLC and funding the trust with interests in that entity might help, but this strategy failed in a case involving an Alaska APT. In re Huber, 493 B.R. 798 (Bankr. W.D. Wash. 2013).
To prevent a non-Delaware court from having jurisdiction, the qualified trustee should have custody of all assets of a Delaware APT.
Federal Tax Consequences
A Delaware APT usually will be a grantor trust for federal income-tax purposes, which means that the client—not the trust—must pay all income taxes on interest and dividends that the trustee receives and on capital gains that the trust incurs. IRC § 677. The IRS has ruled several times, though, that such a trust is a nongrantor trust, which means that the trustee—not the client—must pay all such income taxes, if distributions to the client are controlled by adverse parties (for example, children who will receive assets that are not distributed to the client). See, e.g., PLR 201510001.
Gift and Estate Taxes
If the trust gives the trustee or someone else discretion to distribute trust funds to the client, and if the client retains lifetime and testamentary nongeneral powers of appointment and a power to veto distributions, he will not make a taxable gift when he creates a Delaware APT. Treas. Reg. § 25.2511-2(b). But, if a client does not keep those powers, he probably will make a taxable gift when he creates a Delaware APT, and the trust probably will not be included in the gross estate.
If the creation of a Delaware APT is a completed gift, and if the trust is not includable in the gross estate, a client can allocate GST exemption at the creation of the trust.
As mentioned above, a client should fund a Delaware APT with assets that he does not expect to need. If the Delaware APT gives the trustee discretion to use income or principal for the client, a Delaware corporate trustee will process requests for distributions in accordance with its usual procedures. For the trust to work, the client must give up control. So he should request discretionary distributions rarely, if ever, and should not expect to use the trust as a checking account or to get money whenever he asks. If the client prefers, he may retain the right to receive regular income or unitrust distributions along with the ability to receive principal distributions on a discretionary basis.
A Delaware APT typically will be a grantor trust for federal income tax purposes so that the client will have to pay income taxes on trust income and capital gains that he does not actually receive. The client should keep enough money to pay those taxes and should not ask the trustee every April to exercise its discretion to give the client money to cover them. Alternatively, the trust can direct the trustee to pay (or reimburse the client for) such taxes.
Moving Trusts to Delaware (12 Del. Code §§ 3570(10), (11), 3572(c), 3575)
The Delaware Act provides for the move to Delaware of self-settled trusts created in other states or abroad, and the time that the trust existed before it is moved counts toward the four-year period during which a creditor can pursue a claim against the trust. Thus, a client might be able to move an existing self-settled trust to Delaware that cannot be defeated under the Delaware Act.
Avoid Fraudulent Transfer
If a client makes a transfer, whether he gives money to children, establishes an FLP, or creates a Delaware APT, and does not keep enough assets to pay existing and foreseeable creditors, the client has made a fraudulent transfer and the transfer can be undone. So a client is a good candidate for a Delaware APT if he has surplus assets after performing a realistic assessment of existing and foreseeable assets and liabilities. Inversely, a client is a bad candidate for such a trust if he has—or is about to incur—a large obligation and wants to hide assets to avoid paying it. Nevertheless, if a client must meet a specific debt or claim, he may consider a Delaware APT for assets that are not needed to satisfy that obligation.
The Delaware Court of Chancery has held that creditors’ efforts to set aside transfers to Delaware APTs as fraudulent transfers were time-barred. TrustCo Bank v. Mathews, 2015 Del. Ch. LEXIS 18 (Jan. 22, 2015).
To ensure that a client does not make a fraudulent transfer when establishing a Delaware APT, the qualified trustee probably will require him to provide background information and to complete a solvency letter.
Who May Defeat a Delaware APT (12 Del. Code §§ 3572–3573)
The Delaware Act bars original actions and actions to enforce judgments, including judgments entered outside Delaware, and it requires a creditor to bring an action against a Delaware APT in the Delaware Court of Chancery.
Under the Supremacy Clause of the U.S. Constitution, certain “super creditors,” such as the IRS, the SEC, the FTC, and minor children seeking support can reach the assets of vehicles (for example, tenancy-by-the-entireties property and domestic APTs) otherwise shielded from creditors by state law. Under the Delaware Act, the following four categories of creditors can reach the assets of a Delaware APT.
If a creditor’s claim arises before a client creates a Delaware APT, that creditor must bring suit within four years after creation of the trust or, if later, within one year after the creditor discovered (or should have discovered) the trust. The creditor also must prove by clear and convincing evidence that creation of the trust was a fraudulent transfer.
If a creditor’s claim arises after a client creates a Delaware APT, that creditor must bring suit within four years after the trust’s creation and must prove by clear and convincing evidence that creation of the trust was a fraudulent transfer as to that creditor.
A spouse, former spouse, or minor child who has a claim resulting from an agreement or court order for alimony, child support, or property division incident to a judicial proceeding with respect to a separation or divorce can reach the assets of a client’s Delaware APT at any time, but a spouse whom the client marries after creating the trust may not take advantage of this exception. A surviving spouse probably will not be able to reach the assets of a Delaware APT by electing against the client’s will.
A person who suffers death, personal injury, or property damage before the client establishes a Delaware APT for which the client is liable can reach trust assets at any time.
Consequences If a Delaware APT Is Defeated (12 Del. Code § 3574)
If a creditor proves that one of the above exceptions applies, a client’s Delaware APT will be defeated only to the extent necessary to pay that creditor’s claim and related costs, including attorney’s fees. Thus, each creditor must bring a separate action against the trustee. Unless a creditor proves that the trustee acted in bad faith, that trustee can use trust assets to pay its costs to litigate the claim before satisfying the claim. A beneficiary (including the client) who received a distribution before a creditor brings a successful suit to defeat a Delaware APT can keep the distribution unless the creditor proves that the beneficiary acted in bad faith. The Delaware Act protects trustees, attorneys, and other advisers who work on a Delaware APT.
An important factor in evaluating the effectiveness of Delaware APTs is that Delaware has a long-standing tradition of leadership in the trust industry. The original Delaware Act was written and enacted over a three-month period in 1997, and amendments have been drafted and enacted in short order. As noted above, the Delaware Court of Chancery has held that creditors’ claims that transfers to Delaware APTs were fraudulent transfers were barred by laches. TrustCo, 2015 Del. Ch. LEXIS 18. In other situations, that court has upheld Delaware statutes in difficult cases, such as those that might arise if creditors were to challenge a Delaware APT.
Defending Delaware APTS
If a client lives in Delaware or is an NRA, creditors should not be able to reach the assets of his Delaware APT except in the situations mentioned above. If a client does not live in Delaware but is a resident of the United States, a Delaware APT should afford the same protection, but this cannot be guaranteed because issues under the U.S. Constitution might come into play. The danger is that a court in a state that does not recognize APTs might decide that its law—not Delaware law—applies and order the trustee to pay a creditor, even if the claim is not one that is recognized under the Delaware Act.
There are several reasons why a client’s trust should stand even if he is not a Delaware resident or an NRA. They include:
- • A non-Delaware court may not enter a judgment that binds the trustee of a Delaware APT if it does not have jurisdiction over trust assets or a trustee.
- • A non-Delaware court should defer to Delaware courts on issues that involve a Delaware trust.
- • A judgment against a client is not binding on the trustee of the client’s valid trust.
- • A non-Delaware court should apply Delaware law—not its own law—on questions involving a Delaware APT.
- • Delaware courts might not have to recognize (that is, give full faith and credit to) judgments that non-Delaware courts enter against a trust.
- • Delaware may set deadlines for the enforcement of judgments from other states.
- • Creditors should not be able to reach a Delaware APT if the client ends up in bankruptcy.
No court has considered how effectively a Delaware APT protects assets, so the Delaware APT is not yet fail-safe. But a properly designed and implemented Delaware APT will raise formidable obstacles for creditors. The Delaware APT also offers planning options, outside of creditor protection, that might be of great benefit to clients.