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DAPTs as Tax Planning Tools

A South Dakota Domestic Assets Protection Trust (DAPT) is a valuable tax planning tool—creditor protection aside—for reducing estate and gift tax liability.

Under the Tax Cuts & Jobs Act recently passed by Congress and taking effect for the 2018 tax year, the unified estate/gift tax exemption is increased to $11.2 million per individual and $22.4 million per married couple.  In other words, an individual or married couple is not subject to these taxes unless they give away in life and death more than $11.2 million or $22.4 million, respectively.  This article applies to the few individuals and couples who qualify for these taxes.

Most individuals and couples who breach this tax threshold are involved in many business ventures, each of which carry varying levels and types of liability.  While business entity creation is one means of protecting against personal liability for the business’s debts, another way is through Domestic Asset Protection Trusts (“DAPTs”).  DAPTs are not available in every state, but South Dakota has one of the most robust and comprehensive statutory schemes allowing a grantor to place assets in a DAPT in exchange for creditor protection.  For an explanation of the creditor protection benefits and tradeoffs of DAPTs, see my January blog post here.

Another important benefit of DAPTs involves tax planning.  In terms of planning for minimal estate/gift tax liability, it is often more beneficial to give assets away during life than to have them included as part of one’s gross taxable estate at death.  Gifting during one’s life (creating gift tax liability) provides two fundamental advantages over gifting at death (creating estate tax liability).  First, “lifetime transfers enable any post transfer appreciation in value and any income generated by the transferred asset to escape transfer taxation.”[1]  Second, gift taxes for lifetime transfers have a lower effective tax rate than estate taxes because it is imposed only on the value of the property actually received by the donee after the gift tax has been paid (rather than taxing the entire value of the gross estate).  The disadvantage of lifetime gifts is the loss of controlling, and benefiting from, the asset. 

Lifetime gifts are only more beneficial from a tax perspective if they avoid estate tax.  Generally, an asset that has been gifted during life and subjected to gift tax will be excluded from the taxpayer’s gross taxable estate at death.  But only “completed gifts” will be subject to gift tax and excluded from one’s gross estate.  To qualify as a completed gift, the donor must part with dominion and control without retaining power to change the asset’s disposition, whether for the donor’s own benefit or for the benefit of another.[2]  But if the donor retains the ability to name himself or another as the beneficiary of the gifted asset (i.e. the right to designate who can possess or enjoy the property or its income), then the gift is not complete, and the value of the asset will still be included in the taxpayer’s gross taxable estate at death.[3]

One way to make a completed gift is to place the asset in an irrevocable trust.  But when a grantor retains the right to benefit from an irrevocable trust, traditional law disallows creditor protection for that grantor/beneficiary.  The I.R.S. has clarified that when trust assets are not shielded from a grantor’s creditors, then the grantor retains dominion and control over the assets and has not made a completed gift.  The reasoning is that the grantor could run up debt with no intention of paying it, and the grantor’s creditors could satisfy the debt by accessing the trust assets.

So how does one make a lifetime gift subject to gift tax (and therefore avoiding estate tax) while still retaining the right to benefit from the asset and while shielding the asset from one’s creditors?  South Dakota DAPTs make it all possible.  DAPTs allow grantors to enjoy the tax benefits of lifetime gifting while continuing to benefit from the gifted asset—to have their cake and eat it too! [4] 

This requires the grantor to give up any ability to control or name future beneficiaries and distributions.  This is done by appointing an independent trustee with sole and absolute discretion over distributions.  This removes the grantor’s control over requiring the trustee to make distributions.  The grantor’s retained interest is not an enforceable interest, but is instead a mere expectancy—so the grantor is not entitled to receive anything but can still benefit from discretionary distributions.[5]

It also requires that the assets in the trust be protected from the grantor’s creditors.  This requires spendthrift language in the trust, which expressly prohibits a creditor’s ability to access trust assets to satisfy obligations owed it by the beneficiary.  Spendthrift protection for the grantor is only available in states with statutory schemes allowing for self-settled spendthrift trusts, such as South Dakota’s DAPT statute.  Because South Dakota’s DAPT statute provides such robust creditor protection, creditors have no control over assets transferred to a DAPT. Thus, it is sufficient to make a completed gift under I.R.S. standards, subject to the gift tax, but excluded from the grantor’s taxable estate at death.

South Dakota DAPTS, therefore, allow grantors both creditor protection and tax benefits that are unavailable in most other states.  If you currently qualify or likely will qualify for federal estate/gift tax, contact a South Dakota estate planning attorney to implement these strategies as part of your comprehensive estate plan. Any one of our experienced Sioux Falls attorneys, Sioux City attorneys, or Omaha attorneys would be happy to help you with your estate plan.

[1] Mark R. Krogstad and Matthew W. Van Heuvelen, Domestic Asset Protection Trusts: Examining the Effectiveness of South Dakota Asset Protection Trust Statutes for Removing Assets from a Settlor’s Gross Estate, 61 S.D. L. Rev. 378, 389 (2016).

[2] Treas. Reg. § 25.2511-2(b) (as amended in 1999).

[3] Internal Revenue Code §§ 2036, 2038 (2012).

[4] Krogstad and Van Heuvelen, 61 S.D. L. Rev. at 390.

[5] But if an “implied agreement” exists between the grantor and the trustee, then the grantor may retain too much control for the gift to be complete.