Is a trust your best asset protection option? A trust may shelter you, but most will not. America’s wealthiest families have historically relied upon various trusts to protect their wealth from taxes. Now folks from every economic background use trusts for myriad purposes. Asset protection is one of the more important.
A trust is created by a settlor or grantor (the terms are interchangeable) who funds or gives property to the trust. As the trust creator, the grantor sets the terms under which the donated assets shall be managed and distributed.
The grantor names one or more trustees. The trustee may be the grantor. The grantor designates the beneficiaries who are to benefit from the trust and receive its income and principal. Certain trusts allow the grantor to be both the trustee and the beneficiary. This is common with the living trust.
To consider a trust for protection, you must ask:
- Which trusts can protect your assets from yourcreditors?
- Which trusts can protect assets that you bequeath to your beneficiaries from their creditors?
- How can you improve your trust protection?
- How much asset protection can you get from the different trusts?
You need an irrevocable intervivos trust to shelter your assets from your
creditors. Anytrust that includes the right protective provisions can
lawsuit-proof the trust assets from your beneficiaries’ creditors.
A trust is either intervivos or testamentary. A living trust is created and funded during yourlifetime. It is an intervivos trust. Trusts that you fund upon yourdeath are testamentary. You would usually create it in your last will or living trust. During your lifetime, your assets remain in your name and would be unprotected against your creditors, unless they have otherwise been sheltered.
Trusts are also revocable or irrevocable. You can change or revoke a revocable trust. You cannot revoke or modify an irrevocable trust. Every testamentary trust is irrevocable once you die because you obviously cannot spring back to life to unwind it.
It is important to distinguish a revocable from an irrevocable trust because a revocable trust won’t protect you. For protection you need an irrevocable trust. You also need an irrevocable trust that you presently fund − an intervivos trust.
One serious disadvantage from using an irrevocable intervivos trust for protection is that once you establish and fund the trust, you cannot cancel or modify it and reclaim property you transferred to it. You thus lose both ownership and control over the trust assets. That’s why an irrevocable intervivos trust is seldom used for protection − though such trusts can be useful for estate planning.
A revocable trust will not protect your assets because your creditors can step into your shoes and revoke your trust. For example, assets titled to your revocable living trust are vulnerable to your present and future lawsuits. Nevertheless, a living trust will help you avoid probate. For lawsuit-proof wealth, you need an irrevocable trust or another protective entity. Since you cannot revoke or change an irrevocable trust, your creditors have no greater power to unwind your trust and reclaim its assets. But for an irrevocable trust to protect you, it must be presently funded. Until you transfer assets to your trust, they are your assets, and can be claimed by your creditors.
There are other limitations with trusts to shield assets. One limitation is that you cannot settle your trust for your sole benefit. Forlawsuit protection, you should have no beneficial interest in the trust. You can, however, retain income rights based on some ascertainable standard (health needs, etc.). Some states disallow self-settled trusts for asset protection. The grantor can neither control the trust nor have anybeneficial rights.
Another limitation is that assets fraudulently transferred to the trust can be recovered by present creditors. An irrevocable trust can protect only against future creditors. You should only transfer assets to an irrevocable trust when you are confident that you have no present creditors. But how can you ever be absolutely certain of this? It’s more accurate to say that you shouldn’t transfer assets to an irrevocable trust if you have the likelihood of a present creditor. A present creditor can recover assets from the trust because the transfer was without consideration. In other words, you received nothing in exchange from the trust.
You can see the limitations with trusts. For protection, youmust use an irrevocable trust, relinquish control, and beneficial interest, and still your trust assets may be seized as a fraudulent transfer. Trusts are also set aside when a court concludes that a trust is a sham or that the grantorretained de facto control over the trust.
The irrevocable trust for asset protection imposes a heavy price that most people want to avoid. They want less draconian ways to become lawsuit-proof.
An irrevocable trust can make sense when 1) you would soon gift the assets to your beneficiaries anyway, and 2) you do not foresee needing the assets for your future financial security. Your price, then, is not particularly heavy, if you do not foreseeably need the assets, and the trust will now accomplish what you would eventually do − distribute your assets to your beneficiaries (usually your children) at some future time. Only then, should you consider an irrevocable intervivos trust for wealth preservation.
Common Trust Pitfall
Avoid three common pitfalls if you create an irrevocable intervivos trust. First, reserve no power to revoke, rescind or amend the trust, or retain any rights − directly or indirectly − to reclaim property that you transfer to the trust. Attach nostrings to the assets that you transfer to the trust.
Second, retain no authority on how your trust or its property is to be managed or invested. And reserve no significant power over the trust. You cannot be the trustee, nor should your spouse, relative, or personal friend. Courts closely examine relationships between the grantor and trustee to determine whether the trustee is only the grantor’s alter ego. Unless your trustee is independent, the courts can ignore your trust and yourcreditors can claim the trust assets. A corporate trustee, such as a bank or trust company would not be considered your alter ego. Therefore, their trusteeship will better protect your trust.
Because of these irrevocable trust disadvantages, most people choose other methods to protect their assets. It also explains the popularity of limited partnerships and LLCs which provide excellent asset protection, are revocable, and lets you control your assets.
Revocable trusts (particularly the living trust) are far more common than irrevocable trusts. A revocable trust can help you with your estate planning, but not asset protection. Creditors can claim assets in a revocable trust as easily as assets titled to you individually. If you can revoke or modify your trust, your creditors can claim the assets for their own benefit.
Protect Your Children’s Inheritance
Parents may spend their lifetime scrimping, saving, and sheltering their wealth, and leave their fortune to their children who spend or lose it. A trust can safeguard assets you will leave to your beneficiaries. They too have lawsuits, creditors, divorces, etc. How do you protect their inheritance from their financial and legal problems?
You may not want an irrevocable trust to protect your assets, but it’s frequently smart to set up a trust to protect assets that you bequeath to your beneficiaries, particularly when the beneficiaries are yourchildren or grandchildren.
Trusts can be intervivos or testamentary. With an intervivos trust you transfer assets to your trust during your lifetime. A testamentary trust receives your assets upon your death. Your assets are yours and stay vulnerable to your creditors until you die, when title to these assets passes to the trust.
A revocable trust can protect the trust assets from your beneficiaries’ creditors. Whether you transfer your assets to the trust within your lifetime or upon your death, the one difference between a revocable and an irrevocable trust funded within your lifetime is that the revocable trust won’t protect you as the grantor. Moreover, assets in your revocable trust will be included in your taxable estate. Assets transferred to your irrevocable trust during your lifetime will be excluded from your taxable estate − provided you live at least three or more years thereafter.
Additionally, it is seldom prudent planning to gift substantial amounts outright to children during your lifetime. You may make lifetime gifts to your children to reduce your taxable estate, yet you have those same ever-present dangers of your children squandering their gifts and you losing control over these assets. A trust may also not be the best decision in this scenario.
A smarter solution may be to title your assets in a limited partnership with yourself (and your spouse) as its general partner. You can then transfer to your children, through a trust, a portion of your limited partnership interests each year. In this way, you reduce your taxable estate as you shift your limited partnership interest to your children’s trusts. Meanwhile, your assets will stay safe from your creditors because they are titled to a limited partnership. You remain in control of your assets because you would be the general partner. Your children’s inheritance will be twice protected; once by the limited partnership and again by their irrevocable trust. When you die, your remaining partnership interest will have a discounted estate tax valuation. You can then bequeath this remaining limited partnership interest to your children’s trust. You have hundreds of ways to effectively combine trusts, FLPs, LLCs, and corporations to achieve various lawsuit protection, tax, and estate planning objectives. You can achieve all this while retaining lifetime control over your assets. This should always be an important goal.
For a trust to fully safeguard your beneficiaries’ interest in the trust assets, you need the right trust provisions. These clauses will prevent your beneficiaries’ creditors from claiming their share of the trust principal or income. The provisions will also stop the creditor from asserting any rights that the beneficiaries may have to the income or exercise other powers that could forfeit your beneficiaries’ protection.
The most important trust clause is the anti-alienationor spendthriftprovision. This directly protects the trust assets from the beneficiaries’ creditors. The anti-alienation clause prohibits the trustee from transferring the trust assets to anyone other than the beneficiaries. This includes the trust beneficiaries’ creditors. The spendthrift or anti-alienation clause expressly precludes anyone whose interest is adverse to the beneficiaries (a creditor, ex-spouse, IRS, etc.) from claiming the beneficiaries’ share – whether it be the trust principal or income distributions. This provision is vital for every trust.
The spendthrift clause won’t completely protect the beneficiaries. There are limitations. Several states don’t enforce spendthrift provisions. A spendthrift clause won’t always protect the beneficiaries from bankruptcy, divorce, or tax claims. It won’t protect income distributions previously received by the beneficiaries. Or a spendthrift provision may be poorly drafted or narrowly interpreted by the courts. Its protection largely depends on the drafter’s skill.
Another important protective clause is to give your trustee distribution discretion. For example, your trust may provide that the beneficiaries would receive trust distributions at age 25. But would those distributions be safe if a beneficiary then has a judgment creditor? Or what if a divorce is imminent?
A discretionary clause gives your trustee the right to withhold income and principal distributions that would otherwise be payable to the beneficiaries; if the trustee believes that the distribution would be wasted or claimed by the beneficiaries’ creditors. This discretionary clause can also prevent a wasteful beneficiary from depleting or wasting trust assets — an important consideration when the grantors’ children are the beneficiaries. If you have concerns about whether money that you entrust for your children will be wasted, then add a discretionary provision in your trust. Your trustee can then regulate distributions to your children, avoid or minimize waste, and better prevent creditor seizure.
If your child is not a spendthrift, is his or her spouse? These same provisions can keep the trust assets safe if your child dies or divorces. These provisions can also apply to gifts to your grandchildren.
Spendthrift and discretionary clauses protect trust assets from your beneficiaries’ creditors. The trustee can withhold payments to your beneficiaries. A beneficiaries’ creditor cannot force a trustee to distribute trust assets to the beneficiaries. The creditor can only claim payments received by the beneficiaries. However, the trustee can directly pay third parties on behalf of a beneficiary. This circumvents a creditor attempting to seize funds from the beneficiaries.
For still more protection, add sprinkling provisions to your trust. Sprinkling provisions are common in trusts that are expected to remain in force for ten or more years, and where each beneficiary’s future income or tax situation is uncertain. The trustee can then modify trust distributions through this sprinkling provision. The trustee can either disburse or retain the principal and income for the duration of the trust. The trustee thus determines what each beneficiary will receive, and when.
The trust grantor would specify criteria for the trustee to follow when making distributions. Required minimum income distributions are recommended when the beneficiary is a spouse or dependent child.
The sprinkling provision adds protection but you still cannot retain the right to modify or revoke your sprinkling trust. As with any other asset protection trust, your sprinkling trust must be irrevocable and you cannot retain control. Moreover, your beneficiary cannot be a trustee. Although legally permissible, the trust assets, in such instances, would become vulnerable to the creditors of your trustee-beneficiary. A trustee, who can distribute trust assets to himself as the beneficiary, gives his creditors the same right to force distributions, which the creditor can then seize.
The living trust is very popular in America. A living trust helps you avoid the cost and delay of probate. You can also avoid the dangers from jointly owning assets. But a revocable living trust won’t protect you from lawsuits.
Though a revocable trust won’t protect you, you have the comfort of knowing that you can change or revoke your living trust as often as you can revise your will. But a living trust can cause you to lose lawsuit protection? Several states have ruled that a homesteaded home transferred to a living trust loses homestead protection. Similarly, assets owned between spouses as tenants-by-the-entirety may lose creditor protection from this type of co-ownership when those same assets are instead titled to a living trust.
There are trade-offs between the different ways to title assets. Without a revocable living trust, the court will distribute your assets under your will. This can be expensive, time-consuming, and cumbersome. (Probate costs can consume as much as 4% of an estate and delay estate distributions.) If you bequeath $1 million through your will, your heirs may pay $40,000 in probate costs, and wait years for their inheritances. A living trust circumvents the probate process. Your assets immediately transfer to your beneficiaries.
Have the best of both worlds. Title your assets to a limited partnership (to lawsuit-proof these assets). Have your living trust (which avoids probate) own your limited partnership. When you die, your ownership in the limited partnership immediately transfers through the living trust to your heirs, and avoids probate. During your lifetime your assets would be creditor-protected by the limited partnership.
Irrevocable Life Insurance Trusts
Life insurance is another important asset. Life insurance can have a substantial cash value or death benefit exposed to creditors. Even a term policy without cash value can be a valuable asset in that it will provide your family income and support after you are gone. But will your beneficiaries get the death benefit, or will your creditors? Life insurance can also pay your estate taxes and make funds immediately available to your survivors; thus avoiding the delay and expense of liquidating other assets.
If you own a large life insurance policy, title your insurance policy to an irrevocable life insurance trust (ILIT). An ILIT is specifically designed to own life insurance. As with other trusts, the ILIT has a trustee, beneficiaries, and terms for distributions.
Your ILIT would own your insurance policy. The insurance policy beneficiary would be the trust. When you die, your insurer pays the ILIT trustee, who would follow the trust instructions and distribute the proceeds to the ILIT beneficiaries. Your estate should not be the beneficiary.
An ILIT can be funded or unfunded. An unfunded ILIT’s life insurance premiums are not fully paid. You fund future premiums (give annual premiums to the trustee, who pays the premiums). With a funded ILIT, youtransfer to the trust a fully paid insurance policy or enough income-producing assets to pay the future premiums.
Whether you have an unfunded or funded ILIT, your policy premiums must be directly paid from the trust. Youcannot directly pay the premiums or you’ll lose both the trust’s tax benefits and creditor protection.
The ILIT is irrevocable. It protects the policy’s cash value, death proceeds, and distributions from the trust to the beneficiaries. If life insurance is not fully creditor-protected by your state laws, then an ILIT is essential for protection.
The ILIT — though sometimes important for protection — can save you estate taxes. Because the ILIT owns the life insurance policy, the policy proceeds won’t be included in your taxable estate, nor subject to estate taxes.
Assume you are single and die with a $3 million estate and $1 million of that amount is life insurance. Assume that when you die you have a $2 million death tax exemption. Your estate would then pay an estate tax on $1 million. If the estate tax is 50 %, your estate tax would be $500,000. But your ILIT would remove the $1 million life insurance proceeds from your taxable estate. Your estate would save $500,000 in estate taxes because you reduced your taxable estate to zero.
The ILIT also gives you better control over policy distributions than insurance owned by you personally. When you personally own insurance, your insurance company directly pays the named beneficiaries when you die. An ILIT not only lets you control who receives the proceeds, but also how and when the policy proceeds will be distributed. For instance, you can specify that the ILIT trustee pays estate taxes and other costs (taxes due on IRAs or other retirement plans probate costs, legal fees, other debts, etc.) before the trustee distributes funds to the trust beneficiaries. Or you can direct your trustee to pay your beneficiaries over a period of months or years. You can add spendthrift, anti-alienation, discretionary distribution, and other protective provisions to protect the insurance proceeds from your beneficiaries’ creditors. The ILIT can also avoid court interference if a beneficiary becomes incompetent. Insurance companies won’t pay life insurance proceeds to an incapacitated beneficiary. They require court instructions. The ILIT avoids this unnecessary complication.
Do you intend to gift money to your children? Investigate an irrevocable children’s trust (ICT). It can reduce taxes as well as provide protection. Property that you transfer to a children’s trust cannot be seized by your creditors. It also won’t be included in your taxable estate. Income from the trust would be taxed at the children’s lower income tax rates. These are the reasons for the children’s trust.
The ICT (or Section 2503 Minor’s Trust) by its terms, controls the taxation and asset protection benefits of this trust. While the trust is in effect and the beneficiary is under 21, neither the grantors nor the child’s creditors can claim the trust assets.
There is one disadvantage with the children’s trust. When your child reaches 21, your child can demand the trust assets. Since it is an irrevocable trust, the grantor cannot withhold distributions from the trust. You cannotthusprevent your child from receiving the assets that are then owned by the trust. You can only extend the trust until a later age if your child, at age 21, consents in writing. Carefully consider whether your child (ren) at that young age can properly handle the trust assets.
Charitable Remainder Trusts
Gifting your assets to charity may seem an extreme way to gain creditor-protection, however, our tax laws allow you to give away your property to charity, achieve protection, and use these same assets to generate income for you during your lifetime. For protection, as well as the tax advantages from gifting assets during your lifetime, the Charitable Remainder Trust (CRT) can be your answer.
Here’s an overview of how the CRT works. As the grantor, you select a tax-exempt charity as the beneficiary of your irrevocable trust. When you create and fund the CRT, you make a charitable donation and can claim an immediate tax deduction for the value of the assets contributed to the trust. Although you have gifted the principal, you would be the income beneficiary. Over your lifetime, your trust would pay you a fixed annual income. You thus get an immediate tax deduction and future income from the donated assets.
Assume that you have $200,000 in stocks that were purchased 15 years ago for $60,000. If you sold the stock to invest in treasury bonds, you would pay $21,000 in capital gains taxes on the profit (15% X $140,000 gain). If your treasury bonds are worth $200,000 when you die, your estate may then pay another $88,000 in estate taxes (although future estate taxes are uncertain). Your heirs would inherit, after taxes, only $91,000 from the original $200,000.
So, you don’t sell your stocks. Instead you transfer them to a CRT. You get the same annual income as from treasury bonds for the remainder of your life because you could be the CRT’s income beneficiary. You deduct your $200,000 donation as an immediate charitable contribution. The income from the tax savings from your charitable deduction can buy a $91,000 life insurance policy to cover the $91,000 that your beneficiaries would have received had you donated your stock to the CRT. The net result: a large tax deduction this year, the same perpetual fixed retirement income as with treasury bonds, you donate to your favorite charity, and the donated trust assets are lawsuit-proof.
Do you have appreciated assets? Do you want a fixed lifetime income? Would the CRT’s fixed income satisfy your retirement needs (adjusted for inflation)? If so, a CRT may be a good protective strategy for you — particularly if it can help you achieve your philanthropic goals. Income from the CRTcan be seized by yourcreditors, but even then there are solutions. For example, your income can be protected through a charitable remainder annuity trust (CRAT), if your state exempts annuities from creditor seizure. Other trusts are variations on this theme.
Qualified Personal Residence Trusts
With a Qualified Personal Residence Trust (QPRT, you transfer your residence to the trust and retain a tenancy for ten years. At the end of the term, your residence passes to your beneficiaries. Your objective is to transfer your residence now at its lower value (basis), rather than when youdie and it has a greater value. The QPRT thus reduces estate taxes.
A QPRT can also lawsuit-protect your home. Yourcreditors can only claim yourright to use the property for the remaining term of years (or the rental value for those years). However, your creditor cannot attach or seize the home because it would be owned by the trust. The beneficial remainder interest can be claimed by your beneficiaries’ creditors, unless your trust includes those important spendthrift provisions. At the end of the term, the trustee must distribute or convert the QPRT assets into an annuity. This is a more desirable alternative in states that creditor-protect annuities.
If you are in a second (or third, fourth, or fifth marriage), the Q-TIP (Qualified Terminable Interest Property) trust may interest you. The Q-TIP ensures that your spouse will receive a lifetime income from the trust. The trust principal then passes to your children (or alternative beneficiary) after your spouse dies or remarries.
Q-TIPs are common with second marriages because they preserve your assets for the benefit of thechildren from a prior marriage, rather than the spouse’s children or family, who would become the probable beneficiaries of an estate bequeathed outright to a surviving spouse. Q-TIPs can also protect a spouse when the grantor believes that the spouse may waste the assets during the spouse’s lifetime. A Q-TIP is essentially a spendthrift trust to shelter your assets from your spouse’s creditors or subsequent mates.
Income from the Q-TIP trust must be used solely to benefit the surviving spouse during the spouse’s lifetime, or the trust won’t qualify for the unlimited marital deduction. Estate taxes on the principal are deferred until the surviving spouse dies.
A Q-TIP trust won’t protect yourassets against your creditors, because the Q-TIP is a testamentary trust. However, a Q-TIP trust can shelter your wealth from a spendthrift spouse, a spouse who may have future financial or legal difficulties, or a spouse who may wish to leave your money to his or her children.
The Q-TIP’s trust principal will be safe from your spouse’s creditors, though the income to your spouse would not be protected. Moreover, the trust income must be distributed as earned. The trustee cannot withhold distributions.
You can use a similar irrevocable intervivos marital deduction trust for protection. The objective is to shift marital assets from the higher-risk spouse to the less-at-risk spouse. This is only another form of lifetime gifting. These transfers are also subject to fraudulent transfer claims. A spouse who makes an outright gift must understand that the transferred assets may be lost by a surviving spouse in a later lawsuit or in divorce. It can also be lost to the spouse’s spendthrift spending.
Land trusts, widely used in Illinois, Florida, Georgia, California, Colorado, and a few other states can partially insulate real estate against lawsuits. The land trust can own any real estate — including the family residence. A bank is normally the trustee. The land trust protects the beneficiaries’ interest in the real estate only if the trust has the proper spendthrift and anti-alienation provisions. As the trust beneficiary, you don’t directly own the real estate. The real estate is titled to the trustee. You own only a beneficial interest in the trust. This interest is personal property, not real property.
Owning a beneficial interest in a land trust is not sufficiently protective. Your creditors can seize your beneficial interest. You need more protection. One option is to title your beneficial interest to a limited partnership, LLC or to an irrevocable trust.
Land trusts have two disadvantages. It is frequently difficult to finance land trust property as it’s necessary to temporarily re-convey the property out of the trust to its grantors or beneficiaries to complete the financing. Also, a beneficiary desiring a Section 1031 tax-free, like-kind exchange, must transfer the property from the trust, since a land trust is not a beneficial interest in real property but an interest in personal property.
Privacy, not asset protection, is the land trust’s major advantage. The beneficial owners won’t appear on the public records because the property is titled to the trustee. To the extent secrecy aids protection, the land trust can be helpful.
Nursing home costs can impoverish you as quickly as a lawsuit. Hence, the Medicaid trust. This special purpose trust shelters assets so the grantor can qualify for Medicaid to pay their nursing home costs. Medicaid trusts, of course, chiefly interest those who prefer to leave their money to their children rather than spend it on their own long-term care.
A Medicaid trust is similar to other irrevocable trusts. The grantor (as an individual or couple) transfers their assets to an irrevocable trust. However, unlike other irrevocable trusts, the grantor can be the income beneficiary. Their children or spouse would be the residual beneficiaries. The grantor can receive income from the trust to the maximum amount allowed by Medicaid. But the now, asset-free grantor can qualify for Medicaid nursing home assistance.
The Medicaid trust offers about the same asset protection as any other irrevocable trust. Medicaid trusts prohibit using the trust assets for other health care purposes, and it also limits the beneficiaries’ income to those income limits set by Medicaid. You must create and fund your Medicaid trust 60 months before you apply for Medicaid. That’s its one disadvantage: Few people can anticipate their long-term care needs that far in advance.
Avoid Trust Shams
Also know which trusts to avoid. Promoters of pure trusts, common law trusts or constitutional trusts ensnare a gullible public. These promoters claim that these trusts predate our tax laws and are immune from taxation. Or they claim their trusts can lawsuit-proof your assets. The tax claims are nearly always bogus.
Pure trusts are shams. They won’t give you a legitimate tax benefit, or other benefits beyond what you could get from other trusts. The IRS has challenged these abusive trusts and penalized their promoters and taxpayers who unlawfully used these trusts to avoid taxes. A grantor trust requires the grantor to pay taxes on the trust income. An irrevocable trust pays the taxes on its income. In either case, taxes are payable on trust earnings. A trust is generally notthe way to avoid income taxes.
Can a pure trust creditor-proof your assets? Possibly. The answer depends on whether the trust is irrevocable and whether you surrendered control over the trust. The asset protection and tax benefits that one can derive from any trust will be based solely on its terms and characteristics of the trust, not the name of the trust.
Most pure trusts are simple, revocable grantor or nominee trusts. They compare to living trusts. They will give you neither asset protection nor tax benefits. Avoid organizations or promoters who claim their trust enjoys special powers or immunities. Have your attorney prepare or review your trusts. You want your trust to give you every benefit that you expect — not huge tax troubles.
Gifting for Asset Protection
Gifting can be a sensible strategy to reduce estate taxes and protect your assets. For example, you may save income taxes by transferring income-producing assets to a recipient in a lower tax bracket. Gifts can also reduce your taxable estate (and estate taxes) while you simultaneously reduce the assets exposed to your creditors.
The annual gift tax exclusion currently lets you transfer $12,000 annually per recipient, tax-free − provided your gift is immediately available to the recipient. If you and your spouse jointly own and gift property, your combined annual exclusion doubles to $24,000 per recipient. A couple with three children can gift $72,000 annually, tax-free. You can accelerate your gifting to more rapidly shift vulnerable assets out of your name.
- One option is to transfer your property in exchange for an installment sale note payable over a number of years. You can forgive $12,000 installments per recipient annually, without tax consequences. Your promissory note would be self-liquidating and your transfer would be a fair consideration exchange and therefore not fraudulent. To protect your note from your creditors, title it to a limited partnership or LLC.
- A bypass-generation gift can accelerate your gifting. These gifts, however, may impose a generation-skipping transfer tax of 50% (plus the gift tax that applies to larger gifts). To avoid this tax, use a generation-skipping trust.
- Gift whatever assets are most vulnerable to creditors. Retain those assets that are exempt from creditor claims or are otherwise protected.
- Another option is to transfer property to a minor child through a children’s or minor’s trust. Or make gifts under the Uniform Transfers to Minors Act. But you won’t get absolute protection if your transfer is fraudulent. Your beneficiaries’ creditors, however, cannot seize the funds until distributed to the beneficiaries.
Lawsuit-Proof Your Estate
You can have more debts than assets when you die. An indebted testator may want to bequeath their estate to their heirs free of creditors’ claims. Most people fully pay their debts from their estates, but how can you protect yourself if your debts exceed your assets when you die? Or what if you are sued after you die? It happens. Arrange your affairs so that your assets pass to your heirs free of lawsuits or creditor claims:
- Title your property jointly with right of survivorship to your intended heir (or as tenancy-by-the-entirety). Jointly owned property passes to the surviving joint owner free of creditor claims against the deceased owner. (This is one exception to my prior advice not to own property jointly.)
- Title your property to an irrevocable trust funded during your lifetime (before you have creditors).
- Accelerate your lifetime gifts to deplete your estate (but avoid fraudulent gifts).
- Invest in fixed annuities or other financial investments, which will transform your wealth into an income stream which will pass debt-free to your survivors.
While your living trust won’t insulate your estate from your creditors, your living trust can give you limited protection. For instance, each state sets a time limit for creditors to file claims against an estate. With your assets titled to a living trust, you avoid probate. Avoid probate, and your potential litigants may be less aware of your death. They are then less likely to file a timely claim.
You may anticipate a big inheritance and have a judgment creditor. How can you judgment-proof your inheritance? One solution is to disclaim your inheritance. Any beneficiary can disclaim their inheritance. Thispasses the inheritance on to the next generation. A disclaimer is a particularly good strategy when you prefer your children to receive your inheritance rather than risk losing it to your creditor.
A disclaimer is a complete and unqualified refusal to accept rights or property. You can disclaim gifts and inheritances. Your alternate beneficiaries may be your children, spouse, or anyone else you designate to receive the gift. For a disclaimer to be effective, observe several requirements: 1) put your disclaimer writing, 2) you must not have previously accepted any part of the property (or any benefits of ownership) and 3) your disclaimer must be received by the transferor within nine months from the date of the transfer or the date the document creating the interest (the bequeath or gift) is made.
If you want to bequeath wealth and protect your beneficiaries, change your will. Direct the inheritances to a protective entity that insulates the inheritance from the beneficiaries’ creditors. For example, you may direct the inheritance to 1) a domestic testamentary trust with spendthrift, anti-alienation, and discretionary provisions, 2) an offshore asset protection trust or 3) a limited partnership or LLC. The legacy directed to a protective entity can be structured so that the full benefits of the gift or bequest can still be enjoyed by the beneficiaries.
Six Tips to Build Trust Protection
There are many opportunities to increase trust protection.
- Never put your eggs in one basket. Use multiple trusts and different trustees for different assets. Your creditor will have more difficulty challenging several trusts. Multiple trusts also give you more flexibility to accommodate multiple objectives, beneficiaries, or financial objectives.
- Use a foreign or offshore trust (not a domestic trust) to further discourage litigation and maximize your protection.
- Incrementally transfer assets to your trusts. Smaller, staggered transfers suggest those that were not intended to defraud creditors.
- Add innocent preambles to your trust. For example, your trust may state an estate planning purpose.
- Include one or two beneficiaries other than yourself. A trust that will only benefit you won’t protect you against either your present or future creditors.
- Don’t control your trust. If you control the trust, your creditor can claim its assets.
Yes, You Can Lose Everything!
You may think that your wealth is safe and that you don't need protection. But don't delude yourself and accept reality — for every 60 minutes you spend making money, spend 60 seconds thinking about how to protect it!