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Understanding the
Significance of Trusts
This issue of The
Wealth Counselor addresses a topic that is important to
clients and all wealth planning professionals - trusts. When
used properly, trusts can provide significant advantages to
clients and to the advisors who recommend them. Given the
numerous types of trusts, this newsletter explores the
general advantages of trusts as well as some of the most
common types of trusts.
Planning Tip: According to a recent survey, 70%
of financial advisors expect that more of their clients
will establish 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.
Planning Tip: 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, the revocable trust may not control
disposition of the trust maker's property.
Planning Tip: Unlike with a trust, one cannot
affirmatively transfer title of property during life
using a will. Also, whether estate planning is by will
or trust, it is important to ensure that the client's
property passing pursuant to contract (e.g., by
beneficiary designation for retirement plans and life
insurance) does not thwart the client's planning
objectives set forth in the trust or will.
Asset Protection for the Trust Maker
The goal of asset protection planning is to insulate the
client's assets that would otherwise be subject to the
claims of his or her 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.
Planning Tip: 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 (i.e., it is a
so-called self-settled spendthrift 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 a 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. 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 self-settled spendthrift trusts or 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.
Planning Tip: A handful of states permit
self-settled spendthrift trusts or what are commonly
known as domestic asset protection trusts.
For those clients unwilling to give up a beneficial interest
in their assets to protect those assets from future
creditors, trusts established under the laws of a
jurisdiction that permits self-settled spendthrift trusts or
a trust established under the laws of a foreign country, may
be appealing.
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.
Planning Tip: Consider trusts for the lifetime
of the beneficiaries to provide prolonged asset
protection for the trust assets. Lifetime trusts also
permit the client's financial advisor to continue to
invest the trust assets as the client desired, which
also helps ensure that trust returns are sufficient to
meet the client's planning objectives.
The second caveat follows logically from the first: the more
rights the beneficiary has with respect to 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 from a
trust, so too can a creditor compel a distribution from that
trust.
Planning Tip: The more rights a beneficiary has
to compel distributions from a trust, the less
protection that trust provides for that beneficiary.
Therefore, where asset protection is a significant concern
for the client, it is important that the trust maker not
give the beneficiary the right to automatic distributions
(for example, 5% or $5,000 annually). A creditor will simply
salivate in anticipation of each distribution. Instead, the
client should consider discretionary distributions by an
independent trustee.
Planning Tip: Consider a professional fiduciary
to make distributions from an asset protection trust.
Trusts that give beneficiaries no distribution rights,
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 a client's child becoming divorced 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 the self-settled spendthrift 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.
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 your clients are includible in their
gross estate for estate tax purposes. Clients 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 client'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.
Planning Tip: 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 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.
Planning Tip: With a properly drafted trust,
the trust maker can access cash value through policy
loans.
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).
Planning Tip: Since federal estate tax is
typically not due until the death of the second spouse
to die, clients often use a joint trust owning a
survivorship policy for estate tax liquidity purposes.
However, a joint trust limits the trust makers' access
to the cash value during lifetime. In these
circumstances, consider an individual trust with the
non-maker spouse as beneficiary.
Conclusion
Clients can protect their assets from creditors by placing
them in a well-drafted trust, and they can protect their
beneficiaries from claims or creditors and predators by
keeping those assets in trust over the beneficiary's
lifetime. By working together, the wealth planning team can
ensure that the plan meets each client's unique planning
objectives.
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