Using the $5million Gift Exemption to Create Creditor Protected Safety Net

Commentators are coming up with all sorts of clever ways to take advantage of the new $5million gift exemption that was part of the TRA 2010 legislation. Indeed, those of us who practice extensively in the asset protection planning arena have our own preferences and, not surprisingly, they involve the use of domestic asset protection trusts.

Wealthy client has heard about the new law and contacts us to discuss how he might take advantage of the historically high gift tax exemption–especially since there is some question about whether it will continue after 2012. Since the client and his spouse will almost certainly owe estate tax upon the death of the last to die, they are receptive to any opportunities to reduce the tax. During our meeting we ask them if they are familiar with domestic asset protection trusts. They have heard of the concept but do not have a clear understanding of how they function and what purposes they serve.

We explain that some 12 states have adopted legislation to permit trust settlors to establish self-settled spendthrift trusts. In its simplest form the settlor transfers property to the trust, the settlor reserves for himself rights as a beneficiary, but the settlor’s creditors cannot access the trust property to pay the settlor’s debts. In all cases, to be effective, the transfer of the property to the trust cannot constitute a fraudulent transfer.

We discuss with our client various gifting opportunities whereby he can transfer property to his descendants using the $5million exemption. All income and growth on the transferred assets are outside of client’s estate. Client likes the concept but is concerned that if the economy takes another nosedive perhaps he might need to access the funds. We suggest that he may want to establish a self settled spendthrift trust in a favorable state jurisdiction. Not only can the client achieve estate tax savings but the transferred property is free from creditor claims and the trustee can make distributions to the client on a discretionary basis.

We then launch into a discussion about a technical difficulty. Under I.R.C. Section 2036, trust corpus is treated as having been retained by the decedent to the extent that the transferred property is to be applied towards the discharge of a legal obligation of the decedent. Thus if a creditor can reach trust property, the estate tax advantage may be lost. In Alaska and Nevada the anti-creditor provisions are very broad. In other states, such as Delaware, creditors can reach the trust assets for alimony and child support. Query whether this limited creditor access could cause inclusion. Another technical issue is whether the transfer to the trust is a completed gift. If there is an understanding or pre-existing arrangement between the settlor and the trustee or distribution advisor regarding the exercise of of the discretionary distribution power, the transfer will be treated as an incomplete gift.

Using a domestic asset protection trust to achieve tax savings and creditor protection is a great opportunity. Properly structured, client has gifted his assets and they are outside his estate. But he also remains a discretionary beneficiary who, if hard times return, can be the recipient of trust distributions.