Estate Planning Journal (WG&L)
Volume 38, Number 01, January 2011
Use ‘Powers’ to Build a Better Asset Protection Trust, Estate Planning Journal, Jan 2011
Use ‘Powers’ to Build a Better Asset Protection Trust
A creatively drafted special power of appointment can be used to increase flexibility, asset protection, and anonymity of a trust.
Author: LEE S. McCULLOUGH, III, ATTORNEY
LEE S. McCULLOUGH, III practices exclusively in the areas of estate planning and asset protection in Provo, Utah. He also teaches estate planning as an adjunct professor at the J. Reuben Clark Law School at Brigham Young University
An asset protection trust can provide a person with security and peace of mind by ensuring that some assets are protected against future potential liabilities. State and federal laws support the use of an asset protection trust that is designed and funded in an ethical manner. Fraudulent transfer laws prevent the use of an asset protection trust to hinder, delay, or defraud a creditor.
For the past several decades, most asset protection trusts have been based on the concept of a self-settled trust. 1 Historically, the general rule has been to deny asset protection to a self-settled trust. 2 This began to change when laws were passed in offshore jurisdictions, such as the Cook Islands and the Isle of Man, which protect the assets in a self-settled trust. Beginning with the Alaska Trust Act in 1997, 13 states now offer some degree of asset protection for a self-settled trust:
(7) New Hampshire.
(9) Rhode Island.
Although this concept has dominated the discussion and the practice of designing asset protection trusts, it is not the only option. The special power of appointment, an old reliable tool, can be implemented to replace and improve on the concept of a self-settled trust.
The special power of appointment is perhaps the most powerful and unappreciated tool in estate planning and asset protection. While most estate planners regularly use special powers of appointments to add flexibility to trust documents, most fail to recognize many of the most powerful uses of this tool. Whether designing a trust solely to protect against potential creditors, or to protect against estate taxes as well, a special power of appointment can be used to build a better asset protection trust.
Powers of appointment are nothing new
The concept of a power of appointment has been a part of the English common law for hundreds of years. This concept is well recognized in all 50 states and in the federal tax laws. 3 Although some minor variations in the law pertaining to powers of appointment have occurred over time, the basic principles, which form the basis of this article, have never varied. These basic principles are summarized below.
Key terminology. Familiarity with the following terms is crucial to an understanding of the strategies discussed below:
A power of appointment is a power that enables the donee of the power, acting in a nonfiduciary capacity, to designate recipients of beneficial ownership interests in the appointive property. 4The “donor” is the person who created the power of appointment.The “donee” is the person on whom the power is conferred (and who may exercise the power).The “permissible appointees” or “objects” are the persons for whom the power may be exercised.An “appointee” is a person to whom an appointment has been made.A “taker in default of appointment” is a person who will receive the property if the power is not exercised. 5
A power of appointment is “general” to the extent that the power is exercisable in favor of the donee, the donee’s estate, or the creditors of the donee or the donee’s estate, regardless of whether the power is also exercisable in favor of others. 6 A power that is not general is referred to as a “special” or “nongeneral” power of appointment.
Basic rules pertaining to asset protection and estate tax inclusion. Property that is subject to a presently exercisable general power of appointment is generally subject to the creditors of the donee because it is a power that is equivalent to ownership. 7 On the other hand, property subject to a special power of appointment is exempt from claims of the donee’s creditors. 8 The donee of a special power of appointment is not considered to have a property interest in the property subject to the power because it cannot be exercised for the economic benefit of the donee. 9 Because the donee has no property interest, the property subject to the power of appointment is not included among the property of the donee for purposes of judgment collection, bankruptcy, 10 divorce, Medicaid eligibility, estate tax inclusion, 11 or other determinations that involve the property of the donee.
Similarly, a permissible appointee (including the donor) has no property interest in a power of appointment. 12 Any attempt to include the interest of a permissible appointee for purposes of judgment collection, bankrupty, divorce, Medicaid eligibility, estate tax inclusion, or other determinations that involve the property of the donee would be a logical and practical impossibility because most special powers of appointment include everyone in the world as a permissible appointee, except for the donee, the donee’s estate, and the creditors of the donee and the donee’s estate.
Replacing the self-settled asset protection trust
An irrevocable trust with a special power of appointment that includes the donor as a permissible appointee (referred to herein as a “special power of appointment trust”) can be used to replace and improve on the concept of a self-settled asset protection trust. Both the self-settled asset protection trust and the special power of appointment trust can be designed so that gifts to the trust are incomplete for gift tax purposes 13—and thus not subject to gift tax at the time of the initial transfer. Both of these trusts can also be designed as a grantor trust for income tax purposes so that income from the trust is taxed to the settlor. If the tax treatment for these two trusts is the same, and the ability to benefit the settlor is the same, what is the difference between a self-settled asset protection trust and a special power of appointment trust?
The pros and cons of these two alternatives may be summarized as follows:
(1) No case law supports the asset protection provided by a self-settled asset protection trust because the statutes that allow asset protection for a self-settled trust are relatively new and untested. On the other hand, the inability of a creditor of a permissible appointee to reach the assets of a special power of appointment trust is supported by centuries of common law that is consistent throughout all 50 states in addition to federal bankruptcy courts. 14 In addition, the asset protection provided by a special power of appointment trust is supported by the logical and practical impossibility of ascribing trust liability for all permissible appointees when that class includes every person on earth other than the donee, the donee’s estate, and the creditors of the donee and the donee’s estate.
(2) The common law rule, followed by the majority of states, is that the assets of a self-settled trust are available to the claims of the settlor’s creditors. 15 Many commentators believe that a state that does not grant asset protection for self-settled trusts will not uphold the laws of a state that does grant asset protection for self-settled trusts, because doing so would violate the first state’s public policy. 16 The asset protection provided by a special power of appointment trust is not dependent on the state where the parties reside or the state where the matter is adjudicated.
(3) Many commentators question whether a self-settled asset protection trust will hold up in a bankruptcy court. At least two bankruptcy courts have held that the recognition of an offshore self-settled trust would offend federal bankruptcy policies. 17 A person who files bankruptcy is typically required to disclose any trust in which he or she is included as a beneficiary. In addition, the 2005 changes to the Bankruptcy Code have created a new ten-year limitations period for transfers to self-settled trusts that are meant to hinder, delay or defraud creditors. 18 Even if a bankruptcy court is unable to bring the assets of a self-settled trust into the bankruptcy estate, the court could dismiss the debtor’s case and deny the debtor a discharge under the bankruptcy laws. In contrast, the special power of appointment trust should be irrelevant to a bankruptcy proceeding because the settlor has no beneficial interest in the trust.
(4) Many of the state statutes that grant some form of asset protection for a self-settled trust also include exceptions that allow creditors to seize the assets of a self-settled trust for child support, alimony, transfers made within certain time periods, government creditors, bankruptcy, or certain torts. 19 In contrast, no statutory exceptions allow a creditor of a permissible appointee to reach the assets of a special power of appointment trust.
(5) Plaintiff’s attorneys, creditors, and government agencies often ask if a person is a beneficiary of a trust in order to determine whether the trust assets may be attached or taken into account for various purposes. This opens the trust up to inspection and evaluation by an adverse party, and it may affect a person’s eligibility for certain programs or benefits. The special power of appointment trust is immune to this kind of scrutiny because the settlor is not a beneficiary, and most every person in the world is a permissible appointee.
(6) A self-settled trust governed by the laws of an exotic and foreign jurisdiction often carries with it a negative stigma and a perception of wrongdoing. Upon learning that a person is a beneficiary of a self-settled trust in a foreign jurisdiction, judges, juries, and government agencies are likely to view the person as a criminal who is attempting to avoid the law. In contrast, a special power of appointment trust established in a domestic jurisdiction for the benefit of a person’s family has the appearance of an ordinary measure established by a law-abiding citizen for estate planning purposes.
(7) The self-settled asset protection trust requires the appointment of a trustee or co-trustee in one of the jurisdictions where self-settled trusts are allowed (with some jurisdictions requiring the use of a corporate trustee 20); the special power of appointment trust does not require the appointment of a corporate trustee or a trustee that is located in a certain jurisdiction.
(8) One may argue that the self-settled trust is safer than the special power of appointment trust because the trustee has a fiduciary duty to the beneficiaries and this ensures that the trustee will not distribute the assets to the wrong people. 21 However, if the trustee has a discretionary power to sprinkle assets among the potential beneficiaries, there is still a chance that the trustee will not distribute the assets according to the wishes of the settlor. The settlor of a special power of appointment trust could use the following measures to ensure that the donee of the power does not exercise it inappropriately:
The settlor could appoint one or more co-donees who are required to act together.The settlor could limit the class of permissible appointees.The settlor could appoint a trust protector with power to approve or veto the exercise of a power of appointment.The settlor could grant a trust protector the power to remove and replace a donee.
To illustrate the differences between a self-settled asset protection trust and a special power of appointment trust, consider the following example:
Scenario 1. Dawn creates a self-settled asset protection trust naming her brother as the trustee. She names herself, her spouse, and her children as the beneficiaries. She gives her brother the power to withhold distributions or to sprinkle distributions among the beneficiaries as he determines in his sole and absolute discretion. Dawn funds her self-settled asset protection trust at a time and in a manner that is not considered a fraudulent transfer.
Scenario 2. Michael creates a special power of appointment trust naming his brother as the trustee. Michael names his spouse and children as the beneficiaries, but he does not include himself as a potential beneficiary. He gives his brother the same power to withhold distributions or to sprinkle distributions among the beneficiaries as he determines in his sole and absolute discretion. Michael also gives his brother a special power of appointment to appoint assets to any person other than himself, his estate, or the creditors of himself or his estate. Michael funds his special power of appointment trust at a time and in a manner that is not considered a fraudulent transfer.
In both scenarios, the brother of the settlor has power to withhold assets or sprinkle assets among the spouse and children of the settlor. In both scenarios, the brother of the settlor can transfer all, part, or none of the assets of the trust to the settlor at any time and for any reason.
Now assume that both Dawn and Michael are sued, and a judgment is entered against them. The creditor’s attorneys will ask both Dawn and Michael if either is the beneficiary of any trust. Michael will correctly answer that he is not a beneficiary of a trust. Even if creditors discover that Michael once created a trust, they will have no claim on the trust because Michael is not included as a beneficiary. Dawn, on the other hand, will have to reply that she is the beneficiary of a self-settled trust, and her creditors will then commence an examination of the trust and an attempt to confiscate its assets.
Improving an intentionally defective grantor trust
An intentionally defective grantor trust is a trust that is excluded from the settlor’s estate for gift and estate tax purposes but whose income is attributed to the settlor for income tax purposes. The name comes from the fact that the settlor intentionally includes a “defect” in the trust document that causes the income to be taxable to the settlor (or “grantor”). The purpose of an intentionally defective grantor trust is to protect assets from estate taxes in addition to protecting assets from the potential future creditors of the settlor. An intentionally defective grantor trust is typically used to own life insurance or other appreciating assets. In order to ensure that the assets of the trust are not included in the settlor’s estate, the settlor is not included as a beneficiary of an intentionally defective grantor trust.
The concept of an intentionally defective grantor trust can be greatly improved if the settlor grants a special power of appointment allowing a donee to appoint assets to any person other than the donee, the donee’s estate, or the creditors of the donee or the donee’s estate. The grant of a special power of appointment to a non-adverse party is one way to cause an irrevocable trust to be treated as a “grantor trust” for income tax purposes. 22 This power allows the donee potentially to appoint the assets of the trust back to the settlor. The donee should not be a person who is also a beneficiary of the trust, or the exercise of a special power of appointment may result in a taxable gift. 23 The fact that the settlor and the settlor’s spouse are included as permissible appointees is insufficient to cause the trust assets to be included in their taxable estate because most everyone in the world is a permissible appointee. 24
Example. Sarah and John both create an intentionally defective grantor trust, and both transfer significant assets to the trust by gift and by sale in order to remove the assets from their taxable estates. Sarah’s trust also includes a special power of appointment allowing her brother to appoint assets to any person other than himself, his estate, or the creditors of the brother or his estate. If the estate tax is repealed, if Sarah falls on hard times, or if she decides that she does not want her children to receive a large inheritance, Sarah’s brother can simply appoint the assets to her at any time. John’s trust does not include this special power. Thus, he has no way to benefit from the assets in the trust, and the trustee has no power to give them back to him.
This option to return assets to the settlor may be especially useful if Congress eventually increases the estate tax exemptions while maintaining the step-up in basis for property included in a decedent’s taxable estate. The special power of appointment that is included in Sarah’s trust would allow her brother to appoint sufficient assets back to her to take full advantage of the step-up in basis at her death to the extent of her available estate tax exemption.
Although a special power of appointment is an old familiar tool, it may be used in creative ways to add greater flexibility, greater asset protection, and greater anonymity to a trust. In fact, it may accomplish what was otherwise impossible in that it allows a person to make an irrevocable gift without giving up the possibility that the assets that were given might be returned.
A “self-settled” trust is one in which the settlor is included as a beneficiary of the trust.
See RESTATEMENT (SECOND) OF TRUSTS, section 156.
See RESTATEMENT OF PROPERTY sections 318-369 (1940), RESTATEMENT (SECOND) OF PROPERTY: DONATIVE TRANSERS sections 11.1-24.4 (1986), RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1, and IRC Section 2041.
RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1.
Id. at section 17.2.
Id. at section 17.3.
Id. at section 17.4.
Id. at section 22.1.
See RESTATEMENT (THIRD) OF TRUSTS section 56 comment b (2003).
See 11 U.S.C. section 541.
See Sections 2041 and 2514.
See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) Section 17.2. Also see In re Hicks, 22 BR 243 (Bkrptcy. DC Ga., 1982) and In re Knight, 164 BR 372 (Bkrptcy. DC Fla., 1994).
A transfer to a trust is “incomplete” for gift tax purposes if the settlor retains a power to veto distributions proposed by the trustee. See Reg. 25.2511-2(c).
Supra note 12.
Supra note 2.
A trust is generally governed by the law of the jurisdiction designated in the trust agreement unless that jurisdiction’s law is contrary to a strong public policy of the jurisdiction having the most significant relationship to the matter at issue. See Uniform Trust Act section 107 and Restatement (Second) of Conflict of Laws sections 273 and 280.
See In re Portnoy, 201 B.R. 698, and In re Brooks, 217 B.R. 98.
11 U.S.C. section 548(e).
See Utah Code 25-6-14, Delaware Code Section 3573, Oklahoma Statutes Title 31, section 11.
See Utah Code 25-6-14; Oklahoma Statutes Title 31, section 11.
By definition, a trustee has a fiduciary duty to the beneficiaries of a trust, while a donee of a power of appointment acts in a nonfiduciary capacity and has no duty to the beneficiaries or permissible appointees. See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1.
See Section 674.
See Reg. 25.2514-1(b)(2).
Section 2042(2) provides that a reversionary interest could cause the trust assets to be included in the settlor’s estate if the value of the reversionary interest immediately before the insured’s death exceeds 5% of the value of the trust. Because the special power of appointment is exercisable in the donee’s absolute discretion, the value of the reversionary interest is less than 5% of the value of the trust. See Reg. 20.2042-1(c)(3). If it can be shown that the settlor and the donee had an express or implied understanding that distributions would be made to the settlor, then the assets of the trust could possibly be included in the settlor’s estate under Section 2036(a)(1).
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