The Wealth Advisor
This issue of The Wealth Advisor addresses a topic that is important to many Americans yet is sometimes misunderstood – trusts. In the right circumstances, trusts can provide significant advantages to those who utilize them, particularly in protecting trust assets from the creditors of beneficiaries.
Admittedly this can be a complex topic, but you see its implications in the headlines every day. This newsletter attempts to simplify the subject and explain the general protection trusts provide for their creator (the “trust maker”) as well as the trust beneficiaries. Given the numerous types of trusts, this newsletter explores only the most common varieties. We encourage you to seek the counsel of your wealth planning team if you have questions about the application of these concepts to your specific situation, or if you have questions about specific types of trusts.
Revocable vs. Irrevocable Trusts
Revocable Living Trusts
Asset Protection for the Trust Maker
As a general rule, if a trust maker creates an irrevocable trust and is a beneficiary of the trust, assets transferred to the trust are not protected from the trust maker’s creditors. This general rule applies whether or not the transfer was done to defraud an existing creditor or creditors.
Until fairly recently, the only way to remain a beneficiary of a trust and get protection against creditors for the trust assets was to establish the trust outside the United States in a favorable jurisdiction. This can be an expensive proposition.
However, the laws of a handful of states (including Alaska, Delaware, Nevada, Rhode Island, South Dakota, and Utah) now permit what are commonly known as domestic asset protection trusts. Under the laws of these few states, a trust maker can transfer assets to an irrevocable trust and the trust maker can be a trust beneficiary, yet trust assets can be protected from the trust maker’s creditors to the extent distributions can only be made within the discretion of an independent trustee. Note that this will not work when the transfer was done to defraud or hinder a creditor or creditors. In that case, the trust will not protect the assets from those creditors.
Given this insulation, asset protection planning often involves transferring assets to one or more types of irrevocable trusts. As long as the transfer is not done to defraud creditors, the courts will typically respect the transfers and the trust assets can be protected from creditors.
Asset Protection for Trust Beneficiaries
First, the assets must remain in the trust to provide ongoing asset protection. In other words, once the trustee distributes the assets to a beneficiary, those assets are no longer protected and can be attached by that beneficiary’s creditors. If the beneficiary is married, the distributed assets may also be subject to the spouse’s creditor(s), or they may be available to the former spouse upon divorce.
The second caveat follows logically from the first: the more rights the beneficiary has with respect to compelling trust distributions, the less asset protection the trust provides. Generally, a creditor “steps into the shoes” of the debtor and can exercise any rights of the debtor. Thus, if a beneficiary has the right to compel a distribution from a trust, so too can a creditor compel a distribution from that trust.
Therefore, where asset protection is a significant concern, it is important that the trust maker not give the beneficiary the right to automatic distributions. A creditor will simply salivate in anticipation of each distribution. Instead, consider discretionary distributions by an independent trustee.
Lastly, with divorce rates at or exceeding 50% nationally, the likelihood of divorce is quite high. By keeping assets in trust, the trust maker can ensure that the trust assets do not go to a former son-in-law or daughter-in-law, or their bloodline.
Irrevocable Life Insurance Trusts
Under the laws of many states, creditors can access the cash value of life insurance. But even if state law protects the cash value from creditors, at death, the death proceeds of life insurance owned by you are includible in your gross estate for estate tax purposes. Insureds can avoid both of these adverse results by having an irrevocable life insurance trust own the insurance policy and also be its beneficiary. The dispositive provisions of this trust typically mirror the provisions of the trust maker’s revocable living trust or will. And while this trust is irrevocable, as with any irrevocable trust, the trust terms can grant an independent trust protector significant flexibility to modify the terms of the trust to account for unanticipated future developments.
If the trust maker is concerned about accessing the cash value of the insurance during lifetime, the trust can give the trustee the power to make loans to the trust maker during lifetime or the power to make distributions to the trust maker’s spouse during the spouse’s lifetime. Even with these provisions, the life insurance proceeds will not be included in the trust maker’s estate for estate tax purposes.
Irrevocable life insurance trusts can be individual trusts (which typically own an individual policy on the trust maker’s life) or they can be joint trusts created by a husband and wife (which typically own a survivorship policy on both lives).