Understanding the Significance of Trusts

This article addresses a topic that is important to many Americans yet is sometimes misunderstood—trusts. In the right circumstances and with proper drafting, trusts can provide significant advantages to those who utilize them.

Admittedly this is a complex area of law, but this article reviews the basic principles and types of trusts and explains the protection that trusts can provide for their creator (the grantor, settlor, or trustmaker) as well as the trust beneficiaries. You should seek the counsel of an experienced estate planning attorney if you have questions about the application of these concepts to your specific circumstances, the circumstances of one or more of your beneficiaries, or specific types of trusts.

Revocable versus Irrevocable Trusts

There are two basic types of trusts: revocable trusts and irrevocable trusts. Perhaps the most common type of trust is the revocable trust (also known as a revocable living trust, inter vivos trust, or living trust). As the name implies, a revocable trust is fully revocable by the trustmaker. Thus, assets transferred (or “funded”) to a revocable trust remain within the control of the trustmaker; the trustmaker (or trustmakers, if it is a joint revocable trust) can withdraw, sell, or encumber the trust assets or revoke the trust and have the assets returned. In contrast, an irrevocable trust, as the name implies, is not revocable by the trustmaker.

Revocable Trusts

Revocable trusts do not provide asset protection for the trustmaker. However, revocable trusts can be advantageous to the extent the trustmaker transfers property to the trust during lifetime.

Specifically, revocable trusts can be excellent vehicles for incapacity planning, privacy in postdeath administration, and probate avoidance. In the event of the trustmaker’s incapacity during life, the successor trustee can step in to manage the trust assets for the benefit of the trustmaker without court supervision of a guardianship proceeding. In addition, upon the trustmaker’s death, a public probate proceeding is not needed if there are no assets remaining in the trustmaker’s individual name. It is important to understand that a revocable trust controls only that property affirmatively transferred to the trust or passing to the trust pursuant to contract (for example, by beneficiary designation for retirement plans and life insurance, by pay-on-death designation for cash accounts, or by transfer-on-death registration for investment accounts).

Asset Protection for the Trustmaker

The goal of asset protection planning is to insulate assets that would otherwise be subject to the claims of creditors. In general, a creditor can reach assets owned by a debtor. Conversely, a creditor cannot reach assets not owned by the debtor. This is where trusts come into play. Properly drafted, certain types of trusts can insulate assets from creditors because the trust owns the assets, not the debtor.

As a general rule, if a trustmaker creates an irrevocable trust and is a beneficiary of the trust, assets transferred to the trust are not protected from the trustmaker's creditors. This general rule applies whether or not the transfer was intended to defraud an existing creditor.

However, several jurisdictions have enacted legislation permitting domestic asset protection trusts (or DAPTs), including Alaska, Delaware, Nevada, and South Dakota. Under these states’ statutes, a trustmaker can generally transfer assets to an irrevocable trust and be a trust beneficiary, yet trust assets can be protected from the trustmaker'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. In that case, the trust will not protect the assets from the creditor.

If you are concerned about asset protection but are unwilling to give up a beneficial interest to protect your assets from creditors, consider consulting with an experienced estate planning attorney about a domestic asset protection trust.

Asset Protection for Trust Beneficiaries

A revocable trust provides no asset protection for the trustmaker during the trustmaker’s life. Upon the trustmaker’s death, however, or upon the death of the first spouse to die if it is a joint trust, the trust becomes irrevocable as to the deceased trustmaker's property and can provide asset protection for the beneficiaries, with two important caveats.

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 creditors or 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 or make a withdrawal from a trust, so too can a creditor.

Therefore, where asset protection is a significant concern, it is important that the trustmaker not give the beneficiary the right to automatic or mandatory distributions. A creditor will simply salivate in anticipation of each distribution. Instead, consider a trust that provides for discretionary distributions by an independent trustee. In addition, consider appointing a professional fiduciary such as a bank, financial institution, or trust company to serve as an independent trustee to make discretionary distributions. Trusts that give beneficiaries no rights to compel a distribution but rather give complete discretion to an independent trustee provide the highest degree of asset protection.

Lastly, with divorce rates at or exceeding 50 percent nationally, the likelihood of divorce is quite high. By keeping assets in trust, the trustmaker 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

With the exception of domestic asset protection trusts, a transfer to an irrevocable trust can protect the assets from creditors only if the trustmaker is not a beneficiary of the trust. One of the most common types of irrevocable trusts is the irrevocable life insurance trust.

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 trustmaker’s revocable trust or will. Although this type of 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. Thus, in addition to providing asset protection for the insurance or other assets held in trust, irrevocable life insurance trusts can eliminate estate tax and protect beneficiaries in the event of divorce.

If the trustmaker 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 trustmaker during lifetime or the power to make distributions to the trustmaker's spouse during the spouse’s lifetime. Even with these provisions, the life insurance proceeds will not be included in the trustmaker's estate for estate tax purposes.

Irrevocable life insurance trusts can be individual trusts (such trusts typically own an individual policy on the trustmaker’s life) or they can be joint trusts created by a husband and wife (these trusts typically own a survivorship policy on both lives). Since federal estate tax is typically not due until the death of the second spouse to die, trustmakers often use a joint trust owning a survivorship policy for estate tax liquidity purposes. However, a joint trust limits the trustmakers’ access to the cash value during lifetime. In these circumstances, consider an individual trust with the nonmaker spouse as beneficiary.

Conclusion

You can protect your assets from creditors by transferring them to a well-drafted trust, and you can protect your beneficiaries from claims of creditors and predators by keeping those assets in trust over the beneficiary’s lifetime. By working with an experienced estate planning attorney, you can use trusts to meet your unique planning objectives.