In this week’s post, I thought we would cover something that is important to many Americans yet is sometimes misunderstood – trusts. In the right circumstances, trusts can provide significant advantages to those who utilize them, particularly in protecting trust assets from the creditors of beneficiaries.
Admittedly this can be a complex topic, but you see its implications in the headlines every day. So, let’s try to simplify the subject and explain the general protection trusts provide for their creator (the “trust maker”) as well as the trust beneficiaries. Given the numerous types of trusts, only look at the most common varieties. I encourage you to seek the counsel of a Michigan attorney who focuses on estate planning to help you apply these concepts to your specific situation, or if you have questions about specific types of trusts.
Revocable vs. Irrevocable Trusts
There are two basic types of trusts: revocable trusts and irrevocable trusts. Perhaps the most common type of trust is revocable trusts (aka revocable living trusts, inter vivos trusts or living trusts). As their name implies, revocable trusts are fully revocable at the request of the trust maker. Thus, assets transferred (or “funded”) to a revocable trust remain within the control of the trust maker; the trust maker (or trust makers if it is a joint revocable trust) can simply revoke the trust and have the assets returned. Alternatively, irrevocable trusts, as their name implies, are not revocable by the trust maker(s).
Revocable Living Trusts
As is discussed more below, revocable trusts do not provide asset protection for the trust maker(s). However, revocable trusts can be advantageous to the extent the trust maker(s) transfer property to the trust during lifetime. Revocable trusts can be excellent vehicles for disability planning, privacy, and probate avoidance. However, a revocable trust controls only that property affirmatively transferred to the trust. Absent such transfer, a revocable trust may not control disposition of property as the trust maker intends. Also, with revocable trusts and wills, it is important to coordinate property passing according to contract (for example, by beneficiary designation for retirement plans and life insurance).
Asset Protection for the Trust Maker
The goal of asset protection planning is to insulate assets that would otherwise be subject to the claims of creditors. Typically, a creditor can reach any assets owned by a debtor. Conversely, a creditor cannot reach assets not owned by the debtor. This is where trusts come into play. The right types of trusts can insulate assets from creditors because the trust owns the assets, not the debtor.
As a general rule, if a trust maker creates an irrevocable trust and is a beneficiary of the trust, assets transferred to the trust are not protected from the trust maker’s creditors. This general rule applies whether or not the transfer was done to defraud an existing creditor or creditors.
Until fairly recently, the only way to remain a beneficiary of a trust and get protection against creditors for the trust assets was to establish the trust outside the United States in a favorable jurisdiction. As you might imagine, this can be an expensive proposition.
However, the laws of a handful of states (including Alaska, Delaware, Nevada, Rhode Island, South Dakota, and Utah) now permit what are commonly known as domestic asset protection trusts. Under the laws of these few states, a trust maker can transfer assets to an irrevocable trust and the trust maker can be a trust beneficiary, yet trust assets can be protected from the trust maker’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 or creditors. In that case, the trust will not protect the assets from those creditors. Although Michigan does not currently have a domestic asset protection trust law, I am hopeful that we will in the near future (I happen to be on a committee working on drafting such a law).
Given this insulation, asset protection planning often involves transferring assets to one or more types of irrevocable trusts. As long as the transfer is not done to defraud creditors, the courts will typically respect the transfers and the trust assets can be protected from creditors.
Asset Protection for Trust Beneficiaries
A revocable trust provides no asset protection for the trust maker during his or her life. Upon the death of the trust maker, 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 trust maker’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 creditor(s), or they may be available to the former spouse upon divorce. Trusts for the lifetime of the beneficiaries provide prolonged asset protection for the trust assets. Lifetime trusts also permit your financial advisor to continue to invest the trust assets as you instruct, which can help ensure that trust returns are sufficient to meet your planning objectives.
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 demand a distribution from a trust, so too can a creditor compel a distribution from that trust. The more rights a beneficiary has to compel distributions from a trust, the less protection that trust provides for that beneficiary.
So, where asset protection is a significant concern, it is important that the trust maker not give the beneficiary the right to automatic distributions. A creditor will simply salivate in anticipation of each distribution. Instead, consider discretionary distributions by an independent trustee. Consider a professional fiduciary to make distributions from an asset protection trust. 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% nationally, the likelihood of divorce is quite high. By keeping assets in trust, the trust maker 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 discussed above, a transfer to an irrevocable trust can protect the assets from creditors only if the trust maker is not a beneficiary of the trust. One of the most common types of irrevocable trust is the irrevocable life insurance trust, also known as a wealth replacement trust, and often referred to as an ILIT.
Under the laws of many states, creditors can access the cash value of life insurance. Reasonable minds differ on whether that is the case in Michigan (read about it here). 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 trust maker’s revocable living trust or will. And while this 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.
If the trust maker 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 trust maker during lifetime or the power to make distributions to the trust maker’s spouse during the spouse’s lifetime. Even with these provisions, the life insurance proceeds will not be included in the trust maker’s estate for estate tax purposes.
Irrevocable life insurance trusts can be individual trusts (which typically own an individual policy on the trust maker’s life) or they can be joint trusts created by a husband and wife (which typically own a survivorship policy on both lives).
Conclusion
You can protect your assets from creditors by placing them in 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 a caring attorney who focuses on estate planning, you can help ensure that your planning meets your unique goals and objectives. Why not get started now? Call us at 616-827-7596 to schedule your Peace of Mind Planning Session and put a caring plan in place for you family today!
Michael Lichterman is an estate planning and business planning attorney who helps families and business owners create a lasting legacy by planning for their Whole Family Wealth™. This goes beyond merely planning for finances – it’s about who your are and what’s important to you. He focuses on estate and asset protection planning for the “experienced” generation, the “sandwich generation” (caring for parents and children), doctors/physicians, nurses, lawyers, dentists, professionals with minor children, family owned businesses and pet planning. He takes the “counselor” part of attorney and counselor at law very seriously, and enjoys creating life long relationships with his clients – many of which have become great friends.