Asset Protection With Domestic Trusts

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Asset Protection With U.S. Domestic Trusts

"Placing family limited partnership interests in an offshore trust provides much more protection from lawsuits, and absent a fraudulent transfer, puts your assets out of the reach of predatory lawyers."

Jeffrey M. Verdon, Esq

Using A Domestic Trust For Asset Protection
Protecting Assets Without Defrauding Creditors
Some Problems With Domestic Trusts For Creditor Protection
Frequent Objections To A Domestic Trust
U.S. Asset Protection Trusts

Using A Domestic Trust For Asset Protection

The laws relating to trusts are enormously confusing because there are so many technical exceptions to every general rule. I'm going to try to cut through some of the confusion as much as possible, while avoiding any serious misstatements of law. Part of the confusion arises because certain rules applicable to trusts are different for tax purposes and for other purposes such as asset protection. Unless otherwise stated, the comments in this report deal with asset protection.

Parties to a domestic trust

Every trust will have a grantor/settlor, one or more beneficiaries and one or more trustees. Here are brief explanations of these terms.

1. Grantor/settlor

The person who establishes (whether directly or indirectly) the trust is known as the grantor, settlor, trustor or creator. In this report, I will refer to this person as the grantor.

2. Beneficiaries

Anyone who is to benefit from the income or the corpus (assets or property) of the trust is a beneficiary. Generally, there are two types of beneficiaries. An income beneficiary is entitled to receive some or all of the income of a trust. The remainder beneficiary is to receive whatever is left at the termination of the trust. A beneficiary may be a contingent beneficiary and/or a discretionary beneficiary.

3. Trustee(s)

In order to have a trust, there must be property that is transferred to one or more trustees. The trustee is the person or organization that is empowered to carry out the terms of the trust agreement. Where asset protection is a major concern, the grantor of the trust should not also be a trustee.

Powers of Appointment

When anyone (usually a beneficiary or grantor) is given the power to direct the disposition of trust property, the law calls that a "power of appointment". A power of appointment can be a general power or can be limited.

A general power of appointment is one exercisable in favor of anyone including the donee, his creditors, his estate, and creditors of his estate. A power of appointment is limited when it is exercisable only in favor of persons (or a class of persons) designated in the instrument creating the power.

A power of appointment can be created within a trust or as part of a power of attorney where the POA grants the attorney-infact a general or limited power to appoint any trust property.

Revocable and irrevocable trusts

There are many different types of trusts because a trust is simply a legal instrument that can be drafted to accomplish a wide range of personal or financial goals. Some trusts are "living trusts" that are created when the grantor is alive. "Testamentary trusts" are created by a person's will.

A living trust can either be revocable by the grantor or it can be irrevocable. The income tax, estate tax and gift tax rules vary greatly between revocable and irrevocable trusts.

Asset protection

A revocable grantor trust provides absolutely no legal protection for the assets in the trust from the grantor's creditors.

If a grantor puts property into an irrevocable trust for his spouse and if the transfers are not found to be "fraudulent conveyances" (as explained later), then that property may be protected from the future creditors of the grantor. This assumes that the transfer to the spouse's trust does not cause the grantor to become insolvent at the time of the transfer. If the spouse is also subject to the claims of creditors, then a transfer into an irrevocable trust for the spouse would protect the assets in the trust but not the income from the trust.

When a grantor puts property into an irrevocable trust for the benefit of his spouse, children, grandchildren or other heirs, the only way that future creditors can reach the assets is to convince a court that the transfer was made to intentionally "hinder, delay or defraud" current or potential creditors of the grantor and that the grantor was insolvent as a result of the transfers to the trust.

Unless a trust has a "spendthrift clause", the beneficiaries of an irrevocable trust can transfer the present value of their future income from the trust, thereby making the money available to their creditors.

Income taxes

The U.S. tax laws make it extremely difficult to shift the income tax obligation on income producing property without making a permanent transfer of the property - with no strings attached.

Asset protection and tax benefits can be achieved with a domestic trust when assets are transferred to an irrevocable trust for the benefit of your children or grandchildren so long as you don't keep any control over the money. This usually means that the trust must have an independent trustee.

The tax laws generally treat anyone with a general power of appointment (or certain other powers) as the owner of the property and that person pays the taxes on any income of the trust. An irrevocable trust for asset protection purposes may be a grantor trust for tax purposes. The specific rules for the income taxation of a trust are spelled out in tax code sections 671 through 678.

Under U.S. tax law, the income of a domestic trust is attributed to the grantor unless the trust is irrevocable and unless the grantor has no legal powers to direct the income or assets of the trust to himself, his spouse or his estate. If he has those prohibited powers, the income of the trust will be taxed to the grantor and not to the trust or beneficiaries.

Estate taxes

Transfers to a revocable living trust do not remove the property from the estate of the grantor. The only way a revocable living trust can save estate taxes is by making sure that the first spouse to die leaves at least $600,000 to the grantor's children (or heirs other than a surviving spouse). The balance of the assets then go to the surviving spouse so that both spouses will get the maximum combined estate tax exemption. (Estate tax professionals refer to this as an A/B trust or a credit shelter trust.)

Transfers to an irrevocable trust where the children of the grantor (or other persons) are the beneficiaries will (generally) succeed in removing the property from the taxable estate of the grantor, subject to the restrictions in tax code section 2035.

Gift Taxes

When a transfer in trust does succeed in removing the property from the estate of the grantor, the gift tax rules then become applicable. Where there is an irrevocable transfer in trust for the benefit of children (or others), the transfer may be subject to gift taxes, after deducting any exemptions. Current law permits each person to transfer up to $600,000 over their lifetime without a federal gift tax. Gifts in excess of the exempt amount will usually be taxed.

When property is transferred outright to someone (like a child) without any restrictions, it is considered a "present interest" and is also eligible for the annual exclusion from the gift tax. That exclusion is $10,000 per donee (recipient), per year. Thus, if you have three children and six grandchildren, you could give away up to $90,000 each year, exempt from the gift tax. Your spouse could do the same. The annual exclusions are in addition to the $600,000 lifetime exemption.
However, gifts in trust are generally not considered gifts of a "present interest" and are not eligible for the $10,000 annual gift tax exemption. Such gifts are eligible for the $600,000 lifetime exemption - for each spouse.

Protecting Assets Without Defrauding Creditors

When you are seeking to use an irrevocable trust to protect some family assets from future lawsuits, it's important to be aware of the legal rules against defrauding your present and potential creditors by transferring your property in a manner to prohibit them from getting an attachment in satisfaction of their claims. The law refers to this as a fraudulent conveyance.

. According to Bill Comer, "fraudulent conveyances under the Uniform Fraudulent Conveyance Act are defined as those:

1. made when the transferor was insolvent or was rendered insolvent by incurring an obligation or making a transfer and the obligation incurred or the transfer made was without a fair consideration;

2. conveyances made without fair consideration when the transferor was engaged in or about to be engaged in a business or transaction which leaves the transferor with an unreasonably small capital;

3. conveyances made or obligations incurred without fair consideration when the transferor believes he will incur debts beyond his ability to pay as they mature, and
4. conveyances made or obligations incurred with actual intent to hinder, delay or defraud either present or future creditors."

Some Problems With Domestic Trusts For Creditor Protection

In theory, an irrevocable trust for the benefit of your spouse or your children will remove the property from exposure to your future creditors so long as you don't retain any control over the disposition of the trust property. But theory doesn't always prevail in U.S. courts.

One of the reasons why many informed people are putting their money into offshore trusts is because the laws applicable to creditor's rights have been expanded greatly in this country, over the past two or three decades. U.S. courts frequently have a great bias toward the plaintiffs who are claiming a financial injury. The courts will frequently find the transfers were a fraud against a creditor even though there was no actual intent to avoid payment of any known claims at the time of the transfer

In truth, the greatest risk to losing assets in a U.S. trust to future creditors results from the retention of "strings" by the grantor. Jeffrey Verdon (800-521-0464) says that,

"The retention of rights or (legal) powers over the enjoyment of trust property, while providing some relief from the feeling of loss of control, will frequently result in such property being included in the grantor's estate for purposes of creditor attachment. ... The assets of a trust created by a grantor for his own benefit, even one containing spendthrift provisions, may be reached by his creditors. (Also) ... assets of a discretionary trust may be reached by the grantor's creditors to the extent that such assets may be applied for the benefit of the grantor. Grantors seeking to place assets beyond the reach of their creditors ... must be prepared to sever all ties to such property".

Bill Comer pointed out to me that failure to honor the trust agreement is another frequent problem for grantors. Where the terms of the trust are ignored, the courts will generally ignore the trust as a separate legal entity.

Peter Double - another attorney involved in asset protection structures (310-791-5811) put the matter a lot stronger in a letter to me.

"You simply cannot trust the (U.S.) courts to be on your side where you ... have a valuable amount of assets in an asset protection structure if you leave your assets in the United States and you do not have the money to fight costly appeals against a wrongful judgment. ... The judges simply seize the assets and then let the parties argue whether or not those assets were originally transferred in a fraudulent manner to the domestic irrevocable trust."

Frequent Objections To A Domestic Trust

There are a number of reasons why people concerned about protecting their assets are reluctant to use an irrevocable domestic trust and are attracted to the potential benefits of a foreign trust.

No ability to revoke the trust.
The grantor can't be a beneficiary
Limitations on grantor serving as trustee
Rule against perpetual trusts

Just as the laws vary from state to state in the U.S., they also vary greatly from country to country. Thus, there are countries where creditors can't secure a lien against assets in a trust even though the grantor can revoke the trust, even though the grantor is a beneficiary, even though the grantor is a trustee (or a protector) and even though the trust is perpetual.

U.S. Asset Protection Trusts

During the latter part of 1997 Alaska and New Jersey established trust laws permitting a grantor to be the beneficiary of a self settled trust - meaning the grantor trust would be protected from the claims of future creditors. The first such law was actually enacted in Missouri, but their trust law never received the publicity surrounding the Alaska and New Jersey asset protection trusts. There is a great deal of controversy over these new domestic asset protection trusts in legal circles and there is no case law on which to rely.

Further details about protecting your assets from future lawsuits are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.

NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article.

About the author:

Vernon Jacobs is a CPA/CLU who works as a tax author and consultant. He sponsors and moderates a free discussion group on asset protection and offshore topics. His email address is vkj@rpifs.com. He can be reached by phone or fax at (913) 362-9667.

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