In theory, it should be possible to use a properly structured domestic asset protection trust (DAPT) to receive assets from a settlor and have the assets protected from the settlor’s creditors, while also having completed gift treatment and no estate tax inclusion for the settlor, even though the settlor remains a discretionary beneficiary of the trust.
In non-DAPT jurisdictions, creditors of a settlor can typically reach the assets of a trust the settlor funds even if the settlor’s interest is wholly discretionary. This results in an incomplete gift. In a DAPT jurisdiction such as Nevada or Alaska, however, the assets are protected from the settlor’s creditors (subject to exceptions that vary from state to state). Thus, it has been argued that at the settlor’s death the assets of the trust are not included in the settlor’s estate and thus avoid estate tax. The settlor gets the best of many worlds – the assets grow outside of his taxable estate, the assets are protected from his creditors, and in a pinch the trustee can still apply trust assets for his or her benefit.
In Private Letter Ruling 200944002, the IRS gave much welcome recognition to this result. Based on this recognition, tax advisors are more likely now to proceed with this type of planning.
The lynchpin of this planning is that the local DAPT law of the state provides substantial limits on creditors of the settlor reaching the trust assets. This creditor protection is fairly likely to be respected by courts when the settlor is a resident of the state with DAPT law, and the trust is settled in that state with assets situated in that state. That is all well and good for settlors who reside in such states, but what if the settlor resides outside of such a state? Can the settlor establish a trust in a DAPT jurisdiction and still obtain these tax results?
The private letter ruling does not answer this question, since it involved a settlor who resides in the applicable DAPT jurisdiction. Presently, the law is unsettled as to the effectiveness of the creditor protection as to settlors residing outside of the DAPT state, including possible challenges to the application of such protection due to the Constitution’s Full Faith & Credit Clause. Therefore, while the private letter ruling does provide more authority for a favorable result, there is still a great deal of uncertainty in regard to the results for settlors residing outside the DAPT jurisdiction.