Asset protection refers to strategies you can take to ensure that the estate you leave to your beneficiaries does in fact benefit them. The following table describes some of the concerns that you may have and some of the steps you can take to provide asset protection.*
*Caveat: While there are many ways to protect your assets, please note that asset protection cannot be used to prevent from paying your bills. Fradulent conveyance laws prevent transferring assets to avoid paying creditors.
| Possible Concerns | Strategies |
|---|---|
| You want to make sure that your spouse will have the maximum estate tax protection after you pass away. | Bypass Trust or Disclaimer Trust |
| You may wish to provide first for your spouse and then for your children from a previous marriage. | Bypass Trust and Marital Trust |
| You want to be sure your estate is used for your children’s education and support until they are able to properly manage money. | Trusts for Children |
| You are concerned that your child’s spouse or creditors can make claims against the child’s property. | Trusts for Children |
| Your beneficiary might not be able to manage money. | Spendthrift Trust |
| You want life insurance proceeds to be taken out of your estate (for estate taxes) to be paid out in a lump sum or over time. | Irrevocable Life Insurance Trust (ILIT) |
| Your beneficiary qualifies for government support and you do not want the inheritance to jeopardize government benefits. | Special Needs Trust |
| You want to transfer assets before they appreciate (such as stocks). | Grantor Retained Annuity Trust (GRAT) or Dynasty Trust (Generation Skipping Trust) |
| You want to transfer your house to your children. | Qualified Personal Residence Trust (QPRT) |
DEFINITIONS OF TRUSTS
Below is a brief summary and definitions regarding trusts. Keep in mind that revocable trusts do not provide asset protection. Irrevocable trusts do provide asset protection. Revocable trusts are the ones which you can revoke, amend, and change at any time before you pass away. Irrevocable trusts are the ones which you cannot revoke or amend without a court order. The benefit of an irrevocable trust is asset protection. The disadvantage is loss of control.
Revocable Trust
In a living, or revocable trust, you name yourself as the grantor, the trustee, and the current beneficiary. You then transfer your assets to the trust. The terms of the trust require that the trust is to be used for your benefit during your life. After your death, the living trust becomes irrevocable and continues for the benefit of your intended beneficiaries. There are many reasons that you might want a living trust. Some of them are:
- Assets held by the trust are not probate property and are not subject to the probate process.
- You can name a successor trustee so that if you are incapacitated, the successor trustee is directed by the trust agreement to follow your wishes.
- At your death your successor trustee follows your wishes. You might direct that the trustee hold certain funds in trust for the education of your children, with any remaining funds payable to them when they reach the age of 30.
- Because the living trust is revocable, you can change the trust agreement if you want to. You might consider a change at marriage, the birth or death of a child, divorce, death of a spouse, or the desire to benefit someone not benefitted by the original trust agreement.
- If you have out-of state property, transferring your assets to a trust will avoid probate in that state.
- A living trust is more flexible than a durable power of attorney because it can continue after your death.
Often a living trust is written so that during the grantor’s life, the grantor and the grantor’s spouse are the beneficiaries. If the spouse is surviving at the death of the grantor, the spouse becomes the beneficiary. At the death of the spouse or if the spouse doesn’t survive the grantor, the children become the beneficiaries for the remaining assets. Sometimes the assets are held in trust to pay for the children’s education and support. Then when the children reach some milestone, such as reaching a certain age, the remaining assets are distributed to them. Other people leave assets in long-term trusts for their children to protect the inheritance from the children’s creditors.
Bypass Trusts (Credit Shelter Trusts)
A bypass trust is a tool used by married couples who do not want their heirs to be taxed “twice” on their estates. Normally, when a person dies, leaving a surviving spouse, everything in the dying spouse’s estate is allowed to pass to the surviving spouse tax free (if the spouse is a US citizen). It’s great, but here’s the issue. When both spouses were alive, they each owned half of the estate. Now, the surviving spouse owns the entire estate, which is now double in size and has a greater chance of being exposed to taxation above the exemption allowance. For example, let’s say that the estate tax exemption is $1,000,000. If a couple has a $2,000,000 estate and each spouse owns $1,000,000, when one of the spouses dies and the surviving spouse is a US citizen, it is not taxed at the first death. However, now the surviving spouse has a $2,000,000 estate and it will be subject to estate taxes.
They bypass trust must be drafted into the trust when both of the couple are living, but it is not created until after the death of the first spouse. The bypass trust holds the decedent’s assets up to the exemption amount. The beauty of the bypass trust is that although the money you leave behind is earmarked for your kids, your spouse can tap into the trust fund to meet reasonable living costs. But since the money technically “bypasses” both of your estates, it never gets hit by federal estate taxes.
The bypass trust is used:
- To maximize the use of the decedent’s estate tax exemption amount, in order to minimize estate tax upon the death of the surviving spouse.
- To ensure that the decedent spouse’s property will be disposed of according to the decedent’s wishes, even if the surviving spouse remarries or chooses to adopt a different estate plan for the surviving spouse’s assets.
Disclaimer Trusts
The Disclaimer Trust very simply allows the surviving spouse to decide – after the death of the first spouse – whether he/she wants to disclaim the decedent’s assets to avoid estate taxes.
The Disclaimer Trust in effect says:
- Upon the death of the first spouse everything goes to the surviving spouse.
- The surviving spouse, however, may disclaim (“give up”) all or a part of the assets the surviving spouse is to receive from the death of his/her spouse.
- The assets disclaimed are then put into a Disclaimer Trust -which has the same terms as the Bypass Trust, that is, the surviving spouse retains the right to income for his/her life from the assets placed in the Disclaimer Trust.
The Disclaimer Trust concept allows couples to take a “wait and see” approach to the estate tax issues and to make decisions based on all facts and circumstances when they are actually known. However, this decision must be made within 9 months or this option is forever lost.
Marital Trusts
A marital trust is used to benefit the surviving spouse. There are many reasons for creating such a trust– to provide asset protection for the surviving spouse, or to ensure that your children are the ultimate beneficiaries of your estate. Remember that if your spouse remarries after your death, and you leave your entire estate to your surviving spouse, their new spouse could make claims on the inheritance you had left, either in a divorce or by demanding a share at the death of your surviving spouse. If you leave the inheritance to your spouse in a marital trust, the assets would be protected from the claims of a subsequent spouse.
In today’s world, there are many “blended” families-families with stepchildren. In such families, the natural parent of the children often wants to ensure that his or her children ultimately receive the benefit of that parent’s wealth. The natural parent can provide a marital trust that provides for all income from the estate to go to the surviving spouse (the stepparent of the children). Then, upon the death of the stepparent, the remaining assets go to the children. In this manner, the surviving spouse is not disinherited and the estate ultimately goes to the children.
Marital trusts can be created during life or in conjunction with the bypass trust (above).
Trusts for Children
You can set up a trust for your children, too. The terms of the trust can specify which of the children’s expenses to pay and under what circumstances. Normally, these trusts are used to provide for the support of minor children, and the expenses paid are those incurred by the guardian in providing for the children. For older children, these trusts are often used to pay for the children’s education and medical expenses until they reach a certain age or graduate from college.
The trust assets are protected from the child’s creditor. You can have the trust end at a certain age, last for the lifetime of the child, or even from generation to generation (dynasty trust).
Trusts that parents create while they are alive allow the parents to reduce the parent’s estate and provide a mechanism through which the parents can teach the children about investments and money management. (See my blog on Children’s Trusts)
Spendthrift Trusts
A spendthrift trust is created specifically to provide asset protection for the beneficiary. These trusts are written so that the beneficiary can receive the benefit of the trust, but have no right to demand benefits from the trust. Often the trustee has the power to provide for the beneficiary by paying the beneficiary’s living or other expenses directly to the provider. This means that the beneficiary never has control of the benefits. This can be done to keep the benefits away from creditors or from a beneficiary who cannot be trusted with money.
Many trusts can have spendthrift provisions added to them to provide this asset protection for the beneficiary.
Irrevocable Life Insurance Trust (ILIT)
Many people aren’t aware that all of the proceeds from life insurance policies that they own at death will be included their estate for estate tax purposes. Yes, it is exempt from income taxes to the beneficiary, but it is included in owner’s estate for estate tax purposes. If the policy owner can withdraw the cash value and change the beneficiary, then the policy owner will be deemed to have incidents of ownership over the proceeds and the IRS will tax the proceeds at death.
An Irrevocable Life Insurance Trust (ILIT) is a type of irrevocable trust that is specifically designed to hold and own life insurance policies. Once the ILIT has been set up, the trustee of the ILIT owns the life insurance policy on your life.
The ILIT will be designated as the primary beneficiary of your life insurance policies. Thus, after you die, the insurance proceeds will be deposited into the ILIT and held in trust for the benefit of your spouse during his or her remaining lifetime, and then the balance will pass to your children or other beneficiaries. Aside from this, the ILIT can provide your family with a quick source of cash to pay your estate tax bill but it will not increase your estate tax burden.
Another benefit of the ILIT is that since the insurance proceeds will be held in trust for the benefit of your spouse instead of going directly to your spouse, the proceeds will not be taxed in your spouse’s estate either.
And you can also take the ILIT one step further and set it up as a Dynasty Trust or Generation Skipping Trust for the benefit of your children and future generations.
Special Needs Trust
A Special Needs Trust allows a person with a physical or mental disability, or an individual with a chronic or acquired illness, to have, held in trust for his or her benefit, an unlimited amount of assets. In a properly-drafted Special Needs Trust, these assets do not jeopardize government benefits.
Such benefits may include Supplemental Security Income (SSI), Medicaid, vocational rehabilitation, subsidized housing, and other benefits based upon need. A Special Needs Trust provides for supplemental care over and above that which the government provides.
Grantor Retained Annuity Trust (GRAT)
A Grantor Retained Annuity Trust (GRAT) works like this. The Grantor transfers specific assets into the name of the GRAT and receives an annual annuity payment for a certain number of years. When the term of the GRAT ends, the assets in the GRAT are distributed to the trust beneficiaries.
The Grantor sets the annuity payment so that all of the assets that have been transferred into the GRAT will be returned to the Grantor in the form of the annuity payments. While ordinarily the transfer of assets owned by someone into an irrevocable trust for the benefit of someone else would be deemed a gift for federal gift tax purposes, with a GRAT, since theoretically all of the assets transferred in could come back to the Grantor, the value of the gift to the beneficiaries of the GRAT will be at or close to $0. This is called a “zeroed-out GRAT.”
So why would someone do this – set up a trust for the benefit of someone else but get all of the assets back in the form of annuity payments? Because the Grantor is really betting on the fact that the assets transferred into the GRAT will appreciate in value. So while the Grantor will receive the annuity payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their appreciated value.
Dynasty Trust (also known as Generation Skipping Trust)
A Dynasty Trust is a type of irrevocable trust that is designed to eliminate both estate taxes and generation skipping taxes and continue for as many generations as allowed by applicable state law.
Generation-skipping transfer tax is a tax on gifts made to your grandchildren (or for someone who is 37.5 years younger than you). It is a tax on both outright gifts and transfers in trust to this generation. The purpose of the generation-skipping tax is to prevent families from avoiding estate tax by skipping a generation and transferring property to the next generation.
A Dynasty Trust allows you to protect the assets from both estate taxes and generation skipping taxes.
Qualified Personal Residence Trust (QPRT)
A Qualified Personal Residence Trust (QPRT) allows a gift to the QPRT by its creator (the “grantor”) of his or her personal residence, usually for the ultimate benefit of children, at a “discounted” value. The transfer to the QPRT removes the house from the grantor’s estate, reducing potential estate taxes on the grantor’s death.
The grantor transfers his or her residence to the QPRT but keeps the right to use the residence during a period of the QPRT. At the end of the term, the home is given to the beneficiaries. The home is transferred to the beneficiaries at a discount, and usually a substantial discount, from the home’s actual value because they had to wait during the trust period.
There are a number of technical rules and requirements involved with each trust and, with any estate planning tool, they do not work for everyone. But they are useful and attractive for many families. As always, before proceeding with any strategy or any estate planning, you should consult with an estate planning professional.