|Using Trusts for Asset Protection
Without necessarily using an asset protection trust.
March 17, 2011
It has long been recognized that a "spendthrift" trust, which the Restatement (Third) of Trusts defines as "… a trust that restrains voluntary and involuntary alienation of all or any of the beneficiaries' interests," can be used to protect assets from a third-party beneficiary's creditors. The seminal case in this regard is the 1875 decision in Nichols v. Eaton, in which the United States Supreme Court stated that "[w]e concede that there are limitations which public policy or general statutes impose upon all dispositions of property … We also admit that there is a just and sound policy … to protect creditors against frauds upon their rights … But the doctrine, that the owner of property … cannot so dispose of it, but that the object of his bounty … must hold it subject to the debts due his creditors … is one which we are not prepared to announce as the doctrine of this court."
However, a "self-settled" spendthrift trust (which is a trust in which the settlor is himself a beneficiary; commonly referred to as an "asset protection" trust), is for public policy reasons generally not protected from creditors. And, although a trend is developing whereby more and more states are enacting statutes recognizing the validity of self-settled spendthrift trusts, as self-settled spendthrift trust is by no means the only or even necessarily the best, way to obtain asset protection. This is particularly true where the property to be protected is coming from someone other than the beneficiary himself.
A typical last will and testament for a married person of a certain net worth will provide, if the individual is survived by a spouse, for a division of the estate between a "credit shelter" trust and a marital share so as to defer estate tax until the surviving spouse's death. The tax law generally permits the marital share to pass outright to the surviving spouse or in a special type of qualifying trust (often a QTIP (Qualified Terminable Interest Property) trust). Of course, an outright transfer will be subject to the surviving spouse's creditors while a marital trust will not be subject to the surviving spouse's creditors.
The surviving spouse may, however, be uncomfortable with having a significant portion of their inheritance in trust. This discomfort might be overcome by naming the surviving spouse as a co-trustee, by providing for a broad distribution standard, rather than a more restrictive distribution standard such as "health, education, welfare and maintenance" and/or by providing the surviving spouse with the ability to remove and replace their co-trustee.
Similarly, it would make sense to avoid outright distributions to descendants (which are often made through a trust providing for distributions at specified ages, such as in thirds at ages 25, 30 and 35), since the same mechanism that would give a surviving spouse comfort and control over a marital trust can be utilized to give a descendant comfort and control over their trust.
Trusts and Retirement Benefits
Coincident to its retirement planning purpose, the individual retirement account (IRA), has important asset protection planning features. Specifically, due to the fact that financial security in retirement satisfies an important public policy, the law is well settled that an IRA (to be distinguished, however, from an "inherited" IRA), is generally exempt from creditors. It remains uncertain, however, whether an inherited IRA would provide the same protection against a beneficiary's creditors. Therefore, individuals concerned about creditor protection for their beneficiaries should consider designating a trust for the beneficiary as the IRA beneficiary in lieu of naming the beneficiary directly. The issue with using a trust, however, is that naming a trust will generally accelerate taxable distributions from the IRA and thereby accelerate income taxation. Two types of trusts, however, will not accelerate distributions from the IRA:
1. Conduit Trust. As the name suggests, acts as a conduit between the inherited IRA and the trust beneficiary with regard to the minimum required distributions from the inherited IRA. The minimum required distributions that are being paid out to the beneficiary on a current basis are not protected from the beneficiary's creditors, but the conduit trust does serve to protect the funds remaining in the IRA from creditors.
2. Discretionary Accumulation Trust. In such cases, the trustee is not required to distribute to the beneficiary the minimum required distribution on a current basis. Therefore, both the minimum required distribution amount and the funds remaining in the IRA can continue to be protected from creditors. The issue with a discretionary accumulation trust, however, is the difficulty inherent in qualifying the trust as an appropriate owner of an IRA since, without careful drafting, the beneficiary whose life is used to measure the minimum required distributions will be unclear and distribution from the IRA may be inadvertently accelerated.
Trusts created during life to provide estate and generation-skipping transfer (GST) tax savings by removing the transferred assets, together with any appreciation, from the estate of the settlor, also provide significant asset protection because they divest the settlor of those assets. Such trusts are sometimes called "dynasty" trusts because they are generally structured to continue, at a minimum, for a period beyond the lifetime of the settlor's children in order to leverage an allocation of the settlor's GST exemption.
If the settlor's spouse is named as a discretionary beneficiary of the trust, the settlor might indirectly benefit from the trust fund through the exercise of by the trustee of its discretion to make distributions to the settlor's spouse. Moreover, the same mechanisms that would give a surviving spouse comfort and control over a marital trust can be utilized to give the settlor's spouse (and, thereby, the settlor as well), comfort and control over a dynasty trust.
A dynasty trust wherein the settlor's spouse is a discretionary beneficiary might actually provide more significant asset protection than even an "asset protection" trust because such a trust is ubiquitous as an estate planning vehicle and, therefore, much less controversial and prone to scrutiny. In addition, since the trust provides undisputed estate tax savings, it can help to counter potential claims to the effect that the funding of the trust was a fraudulent transfer made with the intent to hinder, delay or defraud the settlor's creditors.
A self-settled spendthrift (or asset protection) trust can be a useful vehicle for generating protection from creditors, but it is only one of many different types of trusts that can provide such benefits and advisors should not lose sight of the other types of trusts that can fulfill a client's creditor protection goals.
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Daniel S. Rubin, JD, LLM, is a partner in the New York City law firm of Moses & Singer LLP where he concentrates his practice in domestic and international estate and asset protection planning. Rubin is a co-author of the soon-to-be published third edition of the Bureau of National Affairs' Tax Management Portfolio on Asset Protection Planning, No. 810-3rd. He can be reached at 212-554-7899.