How (and When) Do Trusts Provide Asset Protection? - An Overview
Dear Friend and Colleague,
One of the tools we commonly use to shield a client's assets from creditors is a trust. Trusts are used so frequently, and benefits of trusts are so second nature to us, that we sometimes fail to explain some basic trust principles. We're going to ameliorate that shortcoming right here.
Who is Who in a Trust
There are usually three "players" in a trust: the "settlor" (sometimes called the "grantor" or "trustor"), the "trustee," and the "beneficiary." The settlor is the person who creates the trust and transfers the assets to the trust. The trustee is the person to whom the settlor transfers the assets. The trustee is legally charged with following the settlor's instructions with respect to the maintenance and distributions of the trust assets. A trustee may not use trust assets for his own benefit, unless the trust authorizes him to do so. The trustee owes a legal duty of care to the beneficiary. The beneficiary is very passive. He has nothing to do except receive the benefits of the trust from the trustee. In some jurisdictions there may be only two players in a trust. These trusts are called purpose trusts and have no beneficiaries – they are set up to achieve a specific purpose.
What complicates matters is that one person may -- and very often does -- wear more than one hat. The settlor may name herself as a trustee, and may even be a beneficiary. Similarly, a trustee may be a beneficiary.
Clients sometimes ask us who is the "owner" of a trust. Unlike a corporation, a limited liability company or a partnership, trusts don't have "owners." Trusts have settlors, trustees and beneficiaries; that's it. The player who holds legal title to the trust's assets is the trustee, but it is a misnomer to refer to him or anyone else as the "owner" of a trust.
The extent to which a trust will serve to shield a client's assets from creditors depends on whether the client is the settlor or the beneficiary of a trust. Some trusts will shield the assets of the settlor but not those of the beneficiary, and vice versa.
Revocable Trusts and Irrevocable Trusts
A trust is irrevocable if the settlor does not retain the power to revoke it. Assets transferred to an irrevocable trust are deemed to be owned by a separate legal person -- the trustee. As a general rule, a creditor of the settlor will not be able to reach the assets in an irrevocable trust for the simple reason that the settlor doesn't own the transferred assets.
A person may transfer assets to a trustee but retain the power to revoke or amend the trust. If the trust is revocable, the trust provides no asset protection to the settlor. Most living trusts that are created to avoid probate and to reduce estate taxes upon a settlor's death are revocable; they provide no asset protection.
What complicates matters is what happens after a settlor of a living trust dies. Living trusts drafted for married couples in California usually divide into at least two subtrusts when the first of the two spouses dies. The division is done solely to reduce estate taxes, by doubling up on the estate tax exclusions. Here's how it works. Let's assume that Mr. and Mrs. Brown have an $11 million estate. Mr. Brown dies in 2012 (a year in which the exclusion from estate tax is $5 million) survived by Mrs. Brown. Their living trust is divided as follows:
The estate taxes are reduced because, upon Mrs. Brown's death (i.e. the "second" death), all of the assets in the "Exemption Trust" escape estate taxes. (N.B. The tax code currently provides for the automatic "portability" of the unused exemption of the first spouse to die to the second spouse. This seems to obviate the needs for an A-B trust, but appearances are deceiving. In most instances an A-B trust would still be desirable.)
In order to achieve the estate tax savings, the tax code requires that Mrs. Brown not have the power to amend or revoke the Exemption Trust throughout her lifetime. That part of the living trust became irrevocable upon Mr. Brown's death.
Had a creditor of either Mr. or Mrs. Brown had a judgment entered against either of them throughout their joint lifetime, their living trust would have been completely ineffective to shield any of their assets from creditors. But does the fact that the Exemption Trust is now irrevocable provide Mrs. Brown with any asset protection? Unfortunately, the answer is "sometimes."
If Mr. Brown had had a creditor during his lifetime, the fact that the Exemption Trust is now an irrevocable trust will not prevent Mr. Brown's creditors from attacking the assets in either the Survivor's Trust or the Exemption Trust. §19001 of the Probate Code provides that if a trust was revocable by a decedent, creditors of the decedent may seize the assets of the trust to satisfy their judgment. Of course, Mrs. Brown could use any defense to the seizure of the assets that Mr. Brown could have used.
But that does not mean that the Exemption Trust provides no asset protection. If Mrs. Brown develops a creditor after Mr. Brown's death, it is very likely that the assets in the Exemption Trust are exempt from Mrs. Brown's creditors. After all, the Exemption Trust is an irrevocable trust. The Survivor's Trust, which in most cases is a revocable trust, will provide Mrs. Brown with no asset protection.
Let's assume that Mr. and Mrs. Brown create an irrevocable trust, to which they contribute their assets. They retain no power to amend or revoke the trust. They name themselves and their children as possible beneficiaries. The trustee may, but is not required to distribute any assets to Mr. Brown or Mrs. Brown. The trustee may elect to distribute all of the trust's income and principal to the children, giving nothing to Mr. or Mrs. Brown. Will this irrevocable trust shield their assets from their creditors?
In California, the answer is no. Probate Code §15304 (the "self-settled trust rule") provides that an irrevocable trust in which the settlor is also a beneficiary is invalid against the settlor's creditors, at least to the extent that the settlor might have received a distribution. If the trustee could have distributed all of the trust's income and/or principal to Mr. or Mrs. Brown -- even if the trustee had made no distributions to them -- the creditors could nonetheless reach all of the assets of the trust.
A number of states, notably Nevada, Delaware and Alaska, have abolished their self-settled trust rule, making it possible for a settlor to contribute assets to an irrevocable trust in which the settlor is a beneficiary and still avoid the settlor's creditors. Most of these states require that the trustee of the trust be a resident of the state in which the trust is established.
Is it possible for a California resident to establish a Nevada trust, naming herself as the beneficiary, thereby avoiding the California self-settled trust rule? Perhaps, but the result is by no means certain. At a minimum, the trust would require a Nevada trustee, and the assets would have to be transferred to Nevada, rendering the Nevada trust unusable for California real estate. If a creditor of the California resident were to obtain a judgment in California, the creditor would be required to attempt to enforce the judgment in Nevada. In the Nevada court, the creditor would argue that the Full Faith and Credit Clause of the Constitution requires Nevada to honor the California judgment. The trustee of the trust would argue that Nevada's interest in abolishing its self-settled trust rule is superior to California's interest in retaining it. Who would prevail is anyone's guess. As of today, no court has decided this issue. Stay tuned.
Thus far, we have focused on the ability of a settlor to avoid his own creditors. Is it possible to create a trust to assure that a beneficiary's creditors cannot attach the trust's assets to satisfy a beneficiary's debts?
Yes, and it's easy. All you need to do is include a spendthrift clause in the irrevocable trust, which is a provision that says that any attempted assignment or transfer of a beneficiary's interest in a trust, whether voluntary or involuntary, is void. In California, spendthrift clauses are authorized by Probate Code §15300. There are some exceptions, including judgments for child support and other judgments arising out of the settlor's duty to support a spouse or child. These exceptions aside, with a little careful drafting, all of a beneficiary's creditors can be avoided with a spendthrift clause.
The careful drafting means that the trustee not be required to make a distribution of income and/or principal to a specified beneficiary. If the trust requires the trustee to pay the annual income from the trust 50% to Johnny and 50% to Janey, and Johnny has a creditor, then the creditor can require the trustee to pay 50% of the income to the creditor, not Johnny. Unfortunately, many trusts that are created for estate planning and probate avoidance purposes have spendthrift clauses that are self-defeating, because these trusts also have provisions that require the trustee to make distributions to specified beneficiaries at specified times.
More Sophisticated Trusts
There are many takes on the traditional irrevocable trust. A trust may be set up to achieve a specified purpose and have no beneficiaries – the purpose trust. A trust may incorporate the concept of a trust protector, who is often given the power to change the trustee, beneficiaries, revoke or terminate the trust or to make changes to the trust. Trusts may be drafted to run for multiple generations (dynasty trusts), to take care of special needs beneficiaries (special needs trusts), to stretch out IRA distributions (retirement trusts) or even to take care of the family poodle (pet trusts).
Trust promoters often tout trusts with impressive sounding names, like The Fortress Trust or the Beneficiary Defective Grantor Trust. Keep in mind that how we refer to a trust is useful only for marketing or as a convenience. What is important is the substance. And for an asset protection trust all that is important are three elements: the trust must be irrevocable, it must contain a spendthrift clause and it cannot be self-settled.
Fraudulent Conveyances -- Once Again
If Mr. Brown has a judgment entered against him on a Monday, and he decides the following Tuesday to create an irrevocable trust and then transfers his assets into the trust, the trust might avoid the probate of his estate upon his death, but it will likely not shield the assets from his creditors. Everything that we have discussed in this letter is contingent upon creating and funding the trust early enough so that a creditor cannot argue that the transfer to the trust was a fraudulent conveyance, i.e. a transfer designed to "delay, defeat or defraud" creditor. The earlier you create an irrevocable trust, the greater will be your chances of success.
Very Truly Yours,