Various states have enacted legislation allowing for the creation of self-settled spendthrift trusts in the last decade. This recent trend of legislation has given rise to domestic asset protection trusts ("DAPTs "). The enactment of DAPT laws in South Dakota and various other states has caused debate as to whether transfers to such trusts can be structured as completed gifts for federal gift tax purposes and whether the assets transferred to such trusts by a settlor can effectively be removed from a settlor's gross estate for federal estate tax purposes. This article will discuss why recent changes to South Dakota's DAPT statutes likely provide settlors the option of reducing their gross estates by making completed gifts to self-settled trusts sitused in South Dakota.
Over the past several years, various states have enacted legislation allowing for the creation of self-settled spendthrift trusts. This recent legislative trend has given rise to domestic asset protection trusts ("DAPTs"). The enactment of DAPT laws in South Dakota and various other states has caused debate as to whether transfers to such trusts can be structured as completed gifts for federal gift tax purposes and whether the assets transferred to such trusts by a settlor can effectively be removed from a settlor's gross estate for federal estate tax purposes. While definitive answers remain unclear, certain private letter rulings from the Internal Revenue Service ("IRS") have offered support for the position that a settlor may make completed gifts and remove assets from his or her gross estate by transferring the assets to a DAPT provided the facts and the applicable state law are consistent with the letter rulings. (1) South Dakota, known for having some of the most progressive trust laws in the country, (2) first enacted its DAPT laws in 2005. (3)
Over the past few decades, there has been a "substantial concern held by Americans about the potential of financially devastating legal judgments." (4) In other words, Americans are worried about potentially losing large sums of money through litigation. For example, the number of lawsuits filed against physicians between 1956 and 1990 "rose from 1.5 claims per every 100 physicians to 15 claims per every 100 physicians." (5) Over the past several years, juries in the United States have awarded large verdicts with potentially devastating consequences to defendants. (6)
On the other hand, protecting one's assets can be difficult. Over the last one hundred years or so, trust laws in the United States have trended weaker and weaker. (7) For example, in the United States, as a matter of public policy, a trust's spendthrift provision was traditionally void with respect to the settlor's creditors where the settlor was also a beneficiary. (8) To obtain such protection, people in the United States were forced to establish trusts in offshore jurisdictions such as the Cayman Islands, Bermuda, or the Cook Islands. (9) These circumstances gave rise to offshore asset protection trusts ("OAPTs"). (10)
OAPTs are trusts settled under the laws of foreign jurisdictions that are advantageous to protecting assets from future creditors. (11) Offshore trusts provide two primary benefits: (1) strong spendthrift protection; and (2) the possibility for a settlor to control and/or benefit from the property held in the trust. (12) Offshore trusts gained popularity in the early 1990s after the Cook Islands codified their existence in 1989. (13) Shortly thereafter, other nations, including the Bahamas, Bermuda, and the Cayman Islands, implemented their own legislation in an attempt to attract the OAPT business to their countries. (14) In 2000, it was estimated that over two trillion dollars ($2,000,000,000,000) in assets were held in offshore trusts. (15)
As money poured out of the United States to offshore trusts, some stateside jurisdictions began taking the "if you can't beat'em, join'em" approach by developing their own set of settlor-friendly laws. Alaska was the first state to take action when its then-governor, Tony Knowles, signed the "Alaska Trust Act" into law on April 1, 1997. (16) The Alaska legislation permitted the establishment of self-settled spendthrift trusts under Alaska law. (17) Thus, it became the first United States jurisdiction to allow an exception to the longstanding rule that permitted creditors to reach a trust beneficiary's interest when the beneficiary was also the settlor of the trust. (18) The purpose of the legislation was to "stimulate economic development in Alaska and establish Alaska as a global financial center." (19) With this legislation, Alaska offered a domestic alternative to the OAPTs with the hope of bringing an influx of assets into the state's banks and trust companies and generating the related trust administration fees. (20) After the enactment of the legislation, domestic settlors could establish their trusts in Alaska and obtain a level of asset protection that previously only existed offshore, but without the risks associated with a foreign jurisdiction. (21) Fifteen other states, including South Dakota, have since followed Alaska's lead and adopted their own legislation permitting trust settlors to establish self-settled trusts. (22) However, not all states have adopted uniform legislation. (23)
This article sets forth the historical background on trust law doctrines that provide beneficiaries a certain level of asset protection and a historical background on the development of DAPTs. (24) This article further analyzes how federal transfer taxes interact with typical DAPTs and how differing state laws affect how DAPTs are utilized as estate planning vehicles. (25) Finally, this article examines South Dakota's DAPT statutes and discusses whether a settlor's transfers to a South Dakota DAPT could be considered completed gifts for federal gift tax purposes and whether the transferred assets could be excluded from the settlor's gross estate for federal estate tax purposes. (26)
Federal transfer tax provisions of the Internal Revenue Code ("Code") have consequences that are ultimately dependent on state trust law. (27) Specifically, whether a gift is a completed gift for purposes of federal gift tax laws under Chapter 12 of the Code or whether an asset is included in a decedent's gross estate for purposes of federal estate tax laws under Chapter 11 of the Code. The determination may depend, in part, on the application of specific provisions of state trust laws. As such, it is important to examine state trust law before addressing specific transfer tax issues related to DAPTs. Of most importance are the state trust laws related to (1) spendthrift provisions and (2) the classification of distribution interests. (28)
A settlor may attempt to shield assets in trust from a beneficiary's current or future creditors through a "spendthrift trust." (29) A spendthrift trust utilizes a spendthrift clause, which "expressly prohibit[s] the voluntary and involuntary alienation (by creditor attachment or otherwise) of the beneficiary's trust interest." (30) In other words, the clause disallows a beneficiary from assigning, or a creditor from reaching, the beneficiary's beneficial interest in the trust. (31) Traditionally, settlors used spendthrift clauses to protect trust assets from the creditors of irresponsible beneficiaries. (32) Thus, in cases where beneficiaries recklessly incurred debt that put the trust assets at risk, the spendthrift clause limited the trust's exposure to the possible invasion of the trust by the creditors of the beneficiaries. (33)
Like many laws in the United States, the concept of spendthrift trusts can be traced to English law. (34) Under English common law, however, spendthrift provisions were traditionally invalid. (35) Even today, English law continues to invalidate a trust's spendthrift protection as a matter of public policy. (36) Nevertheless, "[i]t is a truism that notions of public policy are not static, but vary with time and place, and courts are obliged to revisit public policy if they choose to cite to it as a judicial check against otherwise permissible estate and asset planning opportunities." (37) In 1875, the pendulum of public policy began to swing in the opposite direction as American law diverged from English law and validated spendthrift trusts in the United States. (38) Since 1875, American courts have applied the maxim "cujus est dare, ejus est disponere," which means, "[wjhose it is to give, his it is to dispose." (39) Accordingly, spendthrift clauses are routinely used in the United States to protect a settlor's right to dispose of his or her assets. By providing in the trust instrument that "the interest of a beneficiary of the trust may not be either voluntarily or involuntarily transferred," it restrains the alienation of trust assets and prevents the creditors of the beneficiaries from thwarting the settlor's intent in establishing the trust.
The term "discretionary language" refers to a power given to the trustee to use his or her discretion with respect to making distributions from the trust. A purely discretionary trust is one for which the trustee has unrestricted discretion with regard to: (1) whether distributions are made to the beneficiaries; (2) the amount of any distributions; and (3) the time timing of any distributions. (40) Settlors frequently couple spendthrift language with discretionary language to provide multiple layers of asset protection. (41) The Restatement (Second) of Trusts provides as follows:
[I]f by the terms of a trust it is provided that the trustee shall pay to or apply for a beneficiary only so much of the income and principal or either as the trustee in his uncontrolled discretion shall see fit to pay or apply, a transferee or creditor of the beneficiary cannot compel the trustee to pay any part of the income or principal. (42)...