We live in uncertain times. There’s uncertainty about the economy as well as the possibility of tax increases to address the rising federal debt. For example, there’s renewed interest in proposals that would slash the historically high gift and estate tax exemption. In light of this uncertainty, it’s a good idea to consider estate planning tools that offer asset protection as well as flexibility to adjust your plans to changing circumstances. One such tool is the special power of appointment (SPA) trust.
A SPA trust — sometimes referred to as a SPAT — is an irrevocable trust with a twist: as the creator or “settlor” of the trust, you grant a special power of appointment to a trusted individual, empowering this “appointer,” acting in a nonfiduciary capacity, to direct the trustee to make distributions to a class or group of individuals that would include you (or to anyone else other than the appointer or his or her creditors or estate).
A properly designed SPA trust allows you to remove significant amounts of wealth from your estate, taking advantage of the current gift tax exemption, while retaining the ability to access the trust’s assets — via the appointer — should your needs change in the future. In addition, because you aren’t a beneficiary of a SPA trust, it will not be classified as a self-settled trust, making it possible to enjoy asset protection that’s superior to that available through a domestic asset protection trust (DAPT).
Typically, self-settled trusts aren’t protected against claims by your creditors. But around one-third of the states have statutes that authorize DAPTs. These trusts shield assets against many creditors’ claims, even though the settlor retains an interest in the trust assets as a beneficiary. There’s some risk involved with DAPTs, however, because their effectiveness in protecting assets isn’t well established, particularly for nonresident settlors who live in non-DAPT states.
With a SPA trust, you have no beneficial interest in the trust assets. So long as you don’t retain any improper control over the trust, and distributions to you are entirely within the appointer’s discretion, the assets should be protected against creditors’ claims in all 50 states.
SPA trusts aren’t risk-free, however. Conceivably, a creditor could argue that frequent distributions from the trust to you make you a de facto beneficiary. One way to avoid such a challenge may be for the appointer to direct distributions to your spouse, rather than you, making it more difficult to argue that you’re a de facto beneficiary.
Another risk is that a creditor might challenge a gift to the trust as a fraudulent transfer. (See “Watch out for fraudulent transfer laws.”)
For certain types of assets — particularly business interests — holding these assets in a limited liability company (LLC) owned by a SPA trust can provide significant benefits.
Typically, the trust would own the LLC as a nonmanaging member, while you would be appointed as the LLC’s manager. The LLC provides an extra layer of protection for the underlying assets, while you retain control over the business. Because you don’t own the LLC (it’s owned by the trust), the assets are protected against the claims of your creditors (subject to fraudulent transfer laws). You can even receive management fees from the LLC, which, if reasonable, would be characterized as payment for services rather than distributions from the trust.
In these uncertain times, transferring assets to an irrevocable trust may seem like a risky venture. At the same time, if you hold onto assets there’s a risk that they’ll be exposed to creditors’ claims or, if Congress reduces the exemptions, to gift or estate taxes. A SPA trust allows you to transfer assets while exemption amounts are at record highs, while the special power of appointment provides a safety net in the event you need access to the funds down the road.
Before you transfer assets — whether it’s to a trust, another entity, or an individual — be sure to familiarize yourself with the fraudulent transfer laws in your state. If a creditor successfully challenges a transfer as fraudulent, it can defeat the purpose of a special power of appointment (SPA) trust or other asset protection strategy.
Most fraudulent transfer laws allow creditors to challenge transfers involving either actual or constructive fraud. Actual fraud, which is rare, occurs when you transfer assets with an intent to hinder, delay or defraud any creditor. Constructive fraud, which is much more common, usually means that 1) you transfer assets without receiving a reasonably equivalent value in exchange, and 2) you’re insolvent when you make the transfer or become insolvent as a result. “Insolvent” means that your total debt exceeds the fair value of your assets. Generally, if you’re not paying your debts as they become due, you’re presumed to be insolvent.
To avoid running afoul of the fraudulent transfer laws, before you give away assets — either directly or in trust — determine whether any current or potential creditors are likely to challenge the gift as a fraudulent transfer. And analyze your financial situation to be sure that you aren’t insolvent and won’t render yourself insolvent by making the gift.