Self-settled trusts sound like estate planning nirvana to some, but as with all sophisticated planning tools, the devil is in the details.
Self-settled trusts are also known as domestic asset protection trusts. These are irrevocable trusts for which the same individual is both the person setting up the trust (the settlor) and also a discretionary beneficiary of the trust.
The estate planning magic of the technique is that if you can gift assets to this type of trust and remain a beneficiary, you may achieve the seemingly impossible goal of removing assets from your estate while still being able to benefit from them.
As with many sophisticated estate planning strategies, however, there are risks, complexities and lots of details that have to be tended to. There is also a lot of controversy over whether self-settled trusts are even viable.
YEAR-END GIFT CHALLENGE
In seeking to take advantage of the $5.12 million supersize gift exemption in 2011 and 2012, the biggest hurdle that many people faced was the fear that if they gave that much wealth to their heirs, they might run out of money themselves.
But if a wealthy client gives the gift to a self-settled trust, and not outright to heirs, he or she might accomplish both goals. The trust could name not only the client's children as beneficiaries but also the client's spouse or partner and all descendants, as well. Giving distributions to the spouse or partner could create more security.
These types of spousal/family trusts (sometimes called spousal lifetime access trusts) have become popular, but they do not offer enough security for many people. After all, the rate of divorce is high - and there is a risk that the spouse might die before the client.
But if the client can be a beneficiary too, it might create the security to really capitalize on the large gift exemption. So here's one simple truth about self-settled trusts: If your client is uncomfortable making a gift without being a beneficiary, there may be no other option.
SETTING THEM UP
The number of states permitting these trusts has grown to 14 since Alaska first allowed them nearly 15 years ago. But most are set up in four states: Alaska, Delaware, Nevada or South Dakota.
If a client lives in one of those 14 states, and the assets are located in any of the self-settled-trust states, your plan has a great likelihood of success.
But if the client lives in New York, which does not permit such trusts, and you establish a trust in Alaska, what happens if the client is sued in his or her home state?
The claimant will have to take the judgment to Alaska and seek to have it enforced. If Alaska says no, the claimant will have to appeal to the Supreme Court and argue that Alaska should recognize the judgment of the New York courts under Article IV, Section 1 of the Constitution, commonly referred to as the Full Faith and Credit Clause.
And since there are no cases addressing this issue, the reality is that no one can really say for sure what will happen.
If your focus is on reducing estate taxes, it may seem that you have little reason to care about creditor protection issues. But the ability of creditors to reach trust assets is also the litmus test for determining whether trust assets are included in an estate for estate-tax purposes. So for a self-settled trust's assets to be excluded from an estate, creditors cannot have had the ability to reach the assets in the trust.
If you set up a self-settled trust, the client cannot retain the right to amend or terminate the trust. He or she cannot retain the right to receive the income from it. The client's ability to receive distributions should only be at the discretion of an independent trustee (preferably an institutional trustee).
This should not cause trust assets to be included in the estate, so long as there is no understanding (the IRS often uses the phrase "implied agreement") as to what distributions the client may receive. If the receipt of distributions from the trust is no more than a mere "expectancy," it would appear that a creditor should not be able to reach the property -and that, by extension, the property should be out of the estate.
TROUBLE IN ILLINOIS
The Illinois Supreme Court recently ruled, however, that a self-settled trust wouldn't be respected.
In the case, Rush University Medical Center vs. Sessions, a man named Sessions established a family limited partnership in Colorado. Later, in 1994, he established the Sessions Family Trust in the Cook Islands, in the South Pacific. The trust was a foreign asset protection trust.
Most advisors believe this type of trust to be more secure than the domestic version since it does not face the risk of having to respect another jurisdiction's court rulings under the Full Faith and Credit Clause.
Sessions transferred 99% of the family limited partnership interests as well as some property in Hinsdale, Ill., to the foreign asset protection trust. In the fall of 1995, Sessions made a pledge of $1.5 million to the Rush University Medical Center for the construction of a new president's house on the university's campus in Chicago. Relying on his pledge, the medical center built the house and even held a public dedication honoring Sessions, who executed several codicils to his will reflecting that any portion of the pledge that was unpaid at his death should be paid from his estate.
Sessions died on April 25, 2005, and on Dec. 15, 2005, Rush filed a complaint against Sessions' estate to enforce the pledge. The third count in the complaint contended that if a settlor creates a trust for his own benefit, it is void to existing and future creditors and that those creditors can reach his interest in the trust.
The court ruled: "Traditional law is that if a settlor creates a trust for the settlor's own benefit and inserts a spendthrift clause, the clause is void as to the then-existing and future creditors, and creditors can reach the settlor's interest under the trust." And the Illinois Supreme Court held that common-law creditor rights and remedies remain in full force.
Bottom line: If you set up a trust in Illinois for yourself, your creditors can reach that trust.
While the Rush case makes it sound as if self-settled trusts won't work, remember a few key factors.
First, the issue critical to most self-settling trusts has never been tested at the Supreme Court level. In addition, these trusts have been used with growing frequency for nearly 15 years. Also, laws supporting them have been enacted in a growing number of states.
If you have a high-net-worth client who is planning to use a self-settled trust, you can take prudent steps to lessen the risks that trust assets will be included in his or her estate.
*Demonstrate that the client was solvent before and after any transfers to the self-settled trust. Show that the client retained sufficient non-trust assets to maintain his or her lifestyle and pay debts. A budget plan and investment plan demonstrating that remaining assets should provide for the client's needs with a reasonable degree of probability may be one way to corroborate this.
For example, run Monte Carlo simulations demonstrating an 80% or higher probability that the retained, non-domestic asset protection trust assets will support the client into his or her nineties.
There is no real guidance yet as to what life expectancy, or what degree of assurance, might be necessary to demonstrate sufficient retained assets. Therefore, this will be a judgment call.
* While rules of thumb can be quite misleading, some suggest that not more than one-third of a client's assets should be transferred into a self-settled trust.
* The assets transferred to the trust should be viewed as a safety net - and not as assets the client will need to access for income, cash flow or principal to live on.
* Corroborate that the creation of the trust and the transfer of assets to it was not a fraudulent transfer.
DIVORCE AND AGING
* If the client becomes a beneficiary of the self-settled trust only if he or she is no longer married to the spouse the client had when the trust was established (in other words, after the spouse has died or after a divorce), you may avoid the issue. If the client dies before the spouse, he or she will never have been a beneficiary and the trust may not be able to be classified as a self-settled trust.
* If the client is precluded from being a beneficiary for some period of years, it may similarly minimize tax risks. If the trust prohibits the client from being able to receive a benefit for 10 years and a day, for example, you might achieve additional security.
If the client declares bankruptcy within 10 years of the transfer, the bankruptcy trustee can avoid transfers to a self-settled trust or similar device. So, if you delay making the client a beneficiary beyond this time period, you can insulate the trust from that risk.
* Consider having the trust not name the client as a beneficiary at the time of its formation. Instead, give some person the power to appoint a class of beneficiaries (such as descendants of the client's grandfather) that might include the client.
Be aware, however, that this is a real risk. If the person holding this power is not a fiduciary, then there would be no standard that a court could impose on him or her to appoint your client. Would your client be able to sleep at night?
* The trust agreement could designate a person, such as the trust protector or independent trustee, as having the authority to remove the client as a discretionary beneficiary. If a claim were filed or the client were on his deathbed, he could be immediately removed as a beneficiary - which arguably could truncate the status of the self-settled trust.
As with all tax planning, an advisor who emphasizes being proactive and cautious might ultimately win the day.
Martin M. Shenkman,CPA, PFS, J.D., is a Financial Planning contributing writer and estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.