Many people believe that asset protection trusts can magically shield all of their assets from creditors or legal judgments. In fact, estate planners rarely speak of asset protection trusts because this raises false expectations. Still, many irrevocable trusts can have design elements that offer a degree of asset protection. However, there are limitations and possible issues with these types of trusts. Here are a few points to consider:
Fraudulent Transfer (aka “Voidable Conveyance”)
One of the major misconceptions about asset protection is the idea that a person can simply transfer assets into a trust to avoid paying a debt or a legal judgment. This is called a “fraudulent transfer” and is illegal. Courts can reverse fraudulent transfers and seize assets to pay off creditors or judgments.
Limits on Asset Protection
Asset protection trusts are not a one-size-fits-all solution to protect all types of assets. Some assets may not be suitable for certain types of trusts. Additionally, the amount of protection offered by the trust depends on the laws of the jurisdiction in which it is established. Some states and countries offer stronger protection than others.
Domestic Asset Protection Trusts
While some states in the U.S. do allow for the creation of domestic asset protection trusts, these can be problematic. These trusts are relatively new legal entities, and there’s still a lot of uncertainty around how well they hold up in court, especially when it comes to interstate and federal cases. If a creditor sues in a state that doesn’t recognize the protection of the trust, the assets could still be at risk.
Furthermore, while these trusts can potentially protect assets from future creditors, they generally won’t shield assets from current creditors or from claims related to child support, alimony, or taxes.
Remember, proper asset protection strategies should be put in place well before any legal issues or claims arise. Once there’s a claim or a lawsuit, it’s usually too late to shield assets effectively, and any attempts to do so could be seen as a fraudulent transfer. Therefore, it’s crucial to consult with a legal expert to ensure you’re properly protecting your assets within the confines of the law.
Self-settled Asset Protection Trust (APT):
This is the No. 1 trust that is being advertised as a magic bullet for all-around asset protection, but buyer beware! A self-settled trust allows the trust settlor to be a discretionary beneficiary of the trust while also protecting the assets from creditors. Jurisdictions such as certain U.S. states, therefore “Domestic Asset Protection Trusts” (Alaska, Delaware, Nevada, and South Dakota, etc.) and offshore countries like the Cook Islands and Nevis have statutes permitting self-settled asset protection trusts. We consider them problematic for California residents and explain why in this blog post.
Family Limited Partnership (FLP) or Family Limited Liability Company (LLC):
While technically not a trust, they are a popular asset protection strategy. They protect assets by consolidating family assets into a single entity and distributing limited partnership interests to family members. Creditors are often deterred by the lack of control and lack of marketability associated with these limited interests. Read more about FLPS here and about Private Family Foundations here.
Spendthrift Trust:
This type of trust is created for the benefit of a person that is often unable or unwilling to control how they spend their money. A spendthrift trust does not allow the beneficiary to sell, spend, or give away the trust’s assets until they are released by the trustee. The assets in a spendthrift trust are not available to the beneficiary’s creditors because the beneficiary does not have control of the assets. However, once the assets are paid out to the beneficiary (released by the trustee), creditors can reach them. Other limitations of California spendthrift trusts are discussed in this post.
Discretionary Trust:
In a discretionary trust, the trustee has the discretion, within the terms of the trust deed, to decide how and when to distribute income or capital to beneficiaries. Because beneficiaries do not have a fixed entitlement to the trust property, their creditors cannot access it. In many cases, a trust may be both a discretionary trust and a spendthrift trust. A trust could give the trustee discretion over distributions (making it a discretionary trust) and include a spendthrift clause to prevent the beneficiary from pledging away their interest in the trust (making it a spendthrift trust). Such a trust would provide a higher level of protection against creditors and potential misuse by the beneficiary.
Hybrid Asset Protection Trust:
Hybrid trusts are not self-settled. A third-party settlor creates the trust for the benefit of discretionary beneficiaries. Later, the settlor may be added as a discretionary beneficiary. This later addition can often provide an added layer of protection against creditors. However, the settlor is at the mercy of the cooperation of others to be added as beneficiary later. See more here.
Dynasty Trust:
A dynasty trust is a long-term trust created to pass wealth from generation to generation without incurring estate taxes. The trust’s assets are not considered part of the beneficiaries’ estates, providing protection from creditors and estate taxes. For an in-depth but also somewhat tongue-in-cheek look at Dynasty Trusts see Dynasty Trusts, Egyptian Funeral Rites, Cryonics, And The Undead.
Charitable Remainder Trust (CRT):
In a CRT, the settlor places significantly appreciated assets into the trust and retains an income stream from the trust for a period of years, after which the remainder goes to a charity. The assets are removed from the settlor’s estate, offering potential protection from creditors. There are several different varieties of CRTs, explained in detail in this post.
Qualified Personal Residence Trust (QPRT):
A QPRT allows a homeowner to transfer a primary or secondary residence to an irrevocable trust while retaining the right to live in the home for a term of years. Once the term ends, the remainder interest passes to the beneficiaries. This potentially removes the home or other residential property from the reach of creditors. However, the main use of the QPRT is as a vehicle that saves federal estate taxes. This is currently not a problem for the vast majority of Americans, but the current law will sunset in 2025 at which time many estates, especially in California, may be affected by the federal estate tax. Read more about QPRTs here, and about the federal estate tax law changes in this post.
Irrevocable Life Insurance Trust (ILIT):
An ILIT owns a life insurance policy on the settlor’s life. This arrangement removes the death benefit from the settlor’s estate, potentially protecting it from creditors. However, a degree of asset protection is a side effect of ILITs (pronounced eye-lits), and by itself not a good reason to set them up. More here.
Each of these strategies has its advantages and drawbacks, and their effectiveness can depend heavily on the specifics of the settlor’s situation, the jurisdiction’s laws, and the precise terms of the trust deed. Therefore, it’s crucial to get legal advice when setting up an asset protection strategy.
Piercing the Shield: The Limits of California Spendthrift Trusts
