Hybrid Trusts?

Quick-Take: A new trust is on our radar. Probably it is not a new trust, just a new label to describe a trust and its terms.

Background: Occasionally you run across a new label or acronym that you have never hear of before. That happened to me this month when I was reading a legal journal, when I came across the name hybrid trust. I confess that I had never heard of that before, and having spent 50+ years as a lawyer, I figured that I had seen just about every type/label of trust there was in existence. But hybrid trust was new to me.

Hybrid Trust: Apparently a hybrid trust is a wealth transfer trust which puts less emphasis on asset preservation. In the context that I read about the hybrid trust, it was distinguished from an asset protection trust, or a qualified dispositions in trust, aka asset protection trust. [MCL 700.1041-700.1050.]

Distinction: A hybrid trust is distinguished from a conventional domestic asset protection trust (DAPT) primarily due to some ‘issues’ that were created by the Uniform Voidable Transactions Act, and Comments to that Uniform Law. Briefly, a hybrid trust is used to avoid ‘voidable transfer’ issues that are inherent in that Uniform Act, which Michigan has adopted. [MCL 566.31-566.45.]

• Section 4: One source of the problem is that when the Uniform Voidable Transactions Act was adopted, the Reporter’s Comments to Section 4 of the Act essentially says that under the Act as written, a transfer to a domestic asset protection trust (or DAPT) is per se voidable.
• Section 10: The other source of the problem are the Comments to Section 10 of the Act. Those Comments note that a claim for relief under the Act is governed by the law of the jurisdiction in which the debtor is located when the transfer is made or the obligation is incurred, a flat statement without regard to the settlor’s choice of the jurisdiction’s trust’s laws to govern their trust. This statement is major departure from the traditional rule that a settlor can choose which jurisdiction’s trust laws will apply, if there are sufficient contacts with that selected jurisdiction. More to the point, the Act provides that a debtor is located in the jurisdiction of their principal residence. 

Accordingly, Section 10 of the Act directly conflicts with most DAPT statutes. A transfer is voidable under the Act and its Comments, but it is nonetheless valid under the states’ DAPT law, creating an inherent conflict. Practically speaking Section 10 effectively rejects the right of another jurisdiction to assert its interests and laws regarding a disputed transfer to a DAPT. [Which explains why more recent adopting states of the Act, but not Michigan, expressly adopt the Act but reject its companion Comments. See Indiana and Arkansas.]

Purpose: A gift or transfer to a hybrid trust can use the settlor’s gift, estate and GST tax exemptions, just like when a domestic asset protection trust (DAPT) is funded. But unlike a DAPT, transfers to an irrevocable hybrid trust are not transfers to a self-settled trust; rather, the transfers are to an irrevocable third-party trust in which the permissible beneficiaries may be wholly discretionary. Because the settlor isn’t a permissible beneficiary and the settlor retains no control over the trust’s assets, the settlor’s creditors cannot reach the assets held in the trust.

• ILIT: If the hybrid trust invests in a life insurance policy on the settlor’s life, and because the settlor-insured in not an initial beneficiary and he/she does not control the trust in any way, any death benefit paid to the hybrid trust will escape estate inclusion on the insured’s death. The settlor can also assign his/her GST exemption to transfers to the trust, so that the trust will have a zero-inclusion ratio and its assets might escape transfer taxation for multiple generations, aka a dynasty trust.

Hybrid Trust Terms: The suggested terms for a hybrid trust include the following:

1. There must be an independent trustee.
2. The trust must be located (sitused) in a jurisdiction that would otherwise authorize a self-settled asset protection trust, like Michigan’s Qualified Dispositions in Trust Act.
3. The trust must have a nexus, or substantial contacts, with the jurisdiction where the selected situs will be honored by its courts.
4. The settlor is not a beneficiary of the trust.
5. The trust beneficiaries need to be discretionary beneficiaries without property interests or rights [MCL 700.7815(1).]
6. The trust may have a trust director (or trust protector) to direct trust investments and/or make distributions.
7. Trust director may not be related or subordinate to the settlor or to the trust beneficiaries.
8. The settlor’s family members, or the trust beneficiaries, may have the power to remove and replace trustees, if the replacements are truly independent and not subordinate.
9. However, a hybrid trust might not work in MIchigan since the trust directors should not serve with any fiduciary responsibilities, which is not the case in Michigan, where trust directors are assigned fiduciary roles. Why this is important is that to try to replicate a DAPT, a trust director could be given the authority to add-back the trust settlor a discretionary beneficiary later.

Conclusion: If you have read this far, you will now concluded that a hybrid trust is intended as a substitute for a DAPT, principally caused by some unfortunate Comments to the Uniform Voidable Transactions Act. A hybrid trust starts out as a conventional third-party trust, where the settlor retains no interest in or control over the trust, yet the settlor may be added back to the trust by a trust director as a discretionary trust beneficiary (just like a DAPT.) So, if you encounter the term hybrid trust hopefully you will have a better understanding what that label means.