By: Randall A. Denha, J.D., LL.M.
An important estate planning goal for many individuals is to be sure that their money ultimately passes to their heirs, rather than their creditors. One common estate planning tool used for this purpose is the trust. Essentially, a trust is a legal arrangement under which the creator (often called a “trust maker” or “settlor”) transfers ownership of assets into the care of another person (the “trustee”) to be administered for the benefit of another person or group of people (the “beneficiaries”). The document that establishes the responsibilities of the trustee and the rights of the beneficiaries is called the “trust instrument”, “trust agreement”, or simply “the trust.”
Protecting assets against loss is a common goal of estate planning. Asset protection trusts come in many different forms and can be used to protect property for the use and benefit of clients as well as their families and other beneficiaries. An asset protection trust is a special type of irrevocable trust in which the trust funds are held and invested by the Trustee and are only distributed on a discretionary basis. The purpose of an asset protection trust is to keep the trust assets secure for the beneficiaries instead of being exposed to loss to the beneficiary’s creditors, in a divorce or to predators.
There are two types of trusts: revocable and irrevocable. One type of trust that will protect your assets from your creditors is called an irrevocable trust. Once the trust creator establishes an irrevocable trust, he or she no longer legally owns the assets he or she used to fund it, and can no longer control how those assets are distributed. By creating an irrevocable trust, the trust maker surrenders the ability to later modify the trust instrument. These can be created offshore or domestically in those states that permit its creation. A revocable trust can be altered, amended or revoked at any time and will not protect the assets transferred to it from the claims of creditors.
Asset protection trusts come in two forms: (1) third party trusts; and (2) self-settled trusts. A third party trust is set up by one party for the benefit of another, while a self-settled trust is set up by one party for their own benefit. Leaving an inheritance outright to a child or grandchild without any strings attached is risky in this day and age of high divorce rates, lawsuits and bankruptcies. There’s also the very real risk that an outright inheritance will be spent or end up in the hands of a spouse instead of in the hands of children or grandchildren. Finally, a beneficiary may be born with a disability or develop one later in life, creating a situation whereby their inheritance is rapidly depleted by the expense of the disability but that same inheritance disqualifies the beneficiary from receiving government help in paying medical and other bills.
There are a number of different types of third party asset protection trusts that clients can establish to ensure their hard earned money is used only for the benefit of their family:
- Trusts for minor beneficiaries – Minor beneficiaries can’t legally accept an inheritance. A trust for the benefit of the minor ensures that they will get the benefit of their inheritance.
- Trusts for adult beneficiaries – Adult beneficiaries who aren’t good with managing money, are in a lawsuit-prone profession, have an overreaching spouse, might get divorced or have an addiction problem, will benefit from a lifetime discretionary trust.
- Trusts for surviving spouses – Clients who are worried that a spouse wion’tt be able to manage their inheritance, will remarry or will need nursing home care, can provide that the spouse’s inheritance will be held in a lifetime discretionary trust.
- Trusts for disabled beneficiaries – Disabled beneficiaries who receive an inheritance typically lose their government benefits and have to spend the inheritance before re-qualifying. On the other hand, an inheritance left to a special needs trust can be used to supplement, not replace, government assistance and will not cause disqualification.
Planning Tip: Asset protection trusts designed for inheritance protection can be as flexible as the client chooses. For example, a beneficiary can be added as a co-trustee at a certain age or after the beneficiary reaches a specific goal, such as graduating from college. Another option is to name a corporate trustee, such as a bank or trust company, but give the beneficiary the right to remove and replace the corporate trustee with another one.
The trust can be designed to make trust distribution standards as limited or as broad as the client chooses. For example, the client can state that the funds can only be used to pay medical bills or for education, or the Trustee can be given broad discretion to make distributions in the best interest of the beneficiary. The client may also want to require the Trustee to take into consideration the beneficiary’s income and other assets before making distributions. Alternatively, the Trustee can be given the authority to deplete the trust in favor of the income beneficiary to the detriment of the remainder beneficiaries. If there are multiple beneficiaries, such as a trust for the benefit of a surviving spouse and children, the Trustee can be directed to give preferential treatment to one or more beneficiaries over the others.
Regarding self-settled trusts as previously written in my February 2017 blog, Michigan has now become the 17th state to permit a domestic asset protection trust. If the rules are met a grantor can now (a) establish a trust with himself or herself as an income and principal beneficiary, (b) control investment decisions, (c) veto distributions, (d) change the trustee, and (e) reserve a testamentary special power of appointment or ability to rewrite who the beneficiaries may be in the trust instrument in a separate will. Separately, a creditor must be timely in bringing claims against a qualified trust. Generally, the creditor must bring the action within the greater of two (2) years from the date the disposition was made or one (1) year from date of discovery, unless the claim is brought under the Fraudulent Transfer Act which could extend the period of time. Any transferor making a qualified disposition must sign an affidavit of solvency attesting to the fact that no creditors are being avoided and such transfer isn’t fraudulent. Put another way, assets transferred into a DAPT are not shielded from creditors until they have been in the trust for two years. Also, assets transferred with the intent to “hinder, delay or defraud” a creditor are also not protected.
Planning Tip: Clients needs to be aware that there are only a limited number of U.S. cases interpreting domestic asset protection statutes. Self-settled domestic asset protection trust planning is still developing. Nonetheless, when layered with other types of asset protection planning, including liability insurance, third party asset protection trusts and limited liability entities, domestic self-settled asset protection trusts offer another tool in the planner’s toolbox designed to put up roadblocks between the client’s assets and creditors
Importantly, a court can undo an individual’s transfer to a trust if it finds that the transfer was made with the intention of defrauding creditors. These transfers are considered fraudulent, and in many cases carry significant legal penalties. This is why it is important to practice asset protection planning well before you even anticipate being the subject of any liability. Moreover, it is imperative that you work closely with experienced and credible legal counsel before engaging in any measure of asset protection.