Although trusts are often treated like a separate legal entity (such as a corporation), a trust is actually a contractual agreement.
There are three parties to this agreement. The 1st party is called a grantor, and is also known as a settler or trustor. The grantor gives some or all of his property to one or more people, who are called trustee(s). The trustees hold legal title to the property, but they do not use the property for their benefit. Instead, they have a fiduciary responsibility to manage trust assets (called the trust ‘corpus’.) for the benefit of a third party, the beneficiaries. Sometimes the grantor and beneficiaries are one and the same, and in this case the trust is self-settled. It is important to note that most states have statutes that do not allow a self-settled trust to provide asset protection for the grantor/beneficiary. Furthermore, case law has repeatedly shown us that when a grantor attempts to make a self-settled trust look like it’s not self-settled (for example, a person puts a home in a trust and lists his children as the only beneficiaries, although he or she continues to live in the house rent-free, thus continuing to benefit from trust assets), the trust is ruled a sham. If the grantor also retains general control over trust assets, then likewise he or she will not be able to protect those assets from creditors.
Therefore, in order for a trust to provide asset protection, the grantor must be willing to 1) Give up control of trust assets, and 2) no longer see any benefit from trust assets (there are some exceptions to this rule, but they are few and far in between.) Those wishing to pass wealth on to their heirs or a charity don’t have a problem with this, and in this case a trust can be used to obtain solid asset protection against the beneficiary’s creditors, and, to a lesser extent, from the grantor’s creditors as well. However, for everyone else a domestic trust is not a viable solution.
Foreign (Offshore) Asset Protection Trusts (FAPTs)
Because most domestic self-settled trusts provide little or no asset protection (there are a few exceptions that we’ll discuss shortly), offshore trusts have been promoted as an alternative. Many offshore promoters argue that setting up a trust and transferring assets outside the U.S., to a country that allows self-settled trusts to provide asset protection, is the best way to go. After all, the offshore trustee is not subject to a U.S. court order, and if trust assets are offshore, then they are outside the reach of almost all creditors. While this is true, one must remember that while the trust and trust assets may be offshore, as long as the grantor is in the U.S., he or she is still subject to the courts. There have been several cases where a grantor was ordered by a judge to repatriate offshore assets, and when s/he failed to do so (whether or not such an action was in their power) they were thrown in jail for contempt of court! Nonetheless, this rather extreme consequence is rare and is usually because the judge viewed the grantor as being either overtly or (more often) covertly uncooperative and dishonest with the courts.
Another setback to offshore trusts is they’re often prohibitively expensive to set up (sometimes costing $25,000 or more to set up), and are also expensive to maintain. After all, a trustee is working for the grantor, and he expects to be paid each year. For these reasons, PF Shield will only occasionally set up an offshore trust. In most circumstances there are simply easier, less expensive and more effective asset protection methods available. However, there are circumstances where an offshore trust makes sense, especially when they coincide with estate planning purposes, or are used to own an offshore management company, and so they remain a tool we use perhaps half a dozen times a year.
Domestic Asset Protection Trusts (DAPTs)
Although most states don’t allow self-settled trusts to protect assets, there are a few exceptions. Alaska, Delaware, Nevada, and Utah, for example, have statutes that under certain circumstances allow a self-settled trust to protect assets. However, one must be extremely careful if using a DAPT, for the following reasons:
- The new bankruptcy laws (the Bankruptcy Abuse Prevention and Consumer Protection Act) do not allow a self-settled trust in any state to protect assets, unless it was set up at least 10 years before the grantor filed bankruptcy. Even if it has been more than 10 years since a trust was set up, there’s no guarantee that a DAPT or FAPT will survive bankruptcy (if FAPT assets are not repatriated, there exists the very real chance that the judge will dismiss the bankruptcy.)
- If you live in a state that doesn’t allow DAPTs, and are sued, the judge may rule that the trust is subject to the laws of your state instead of the DAPT-friendly state. It is then unclear how well the trust will hold up if a creditor then enters the judge’s judgment in the DAPT state. This problem is somewhat ameliorated by having trust assets and the trustee live in the DAPT state. Nonetheless, as long as you live in a non-DAPT state, the trust is at risk.
Personally, I wouldn’t even think about setting up a DAPT for a client unless he, the trustee, and his assets were all located in a DAPT-friendly state. Even then, there are usually easier and better ways to do asset protection.
Trusts and Estate Planning
Trusts are most useful in estate planning. For example, a personal residence trust (PRC) allows a parent to live in a home for a while, while passing ownership to the trust, with the eventual goal of moving out of the home and passing complete ownership to his or her heirs. The benefit is that the home is gifted out of the estate before it appreciates in value (this is called an ‘estate freeze), and the home’s value is further reduced, because the parent retains the right to live in the home rent-free for a number of years. Thus, the home passes to heirs while avoiding probate, the value of the home is ‘frozen’, and the home’s value is further reduced, thus reducing the total tax burden on the parent’s estate when s/he dies. If this trust is irrevocable, then asset protection may also be obtained, since the parent only retains the right to live in the home, and although this right is attachable by a creditor of a parent, it is something the creditor would probably find unattractive.
The Irrevocable Life Insurance Trust (ILIT)
Another estate planning use of trusts is the Irrevocable Life Insurance Trust (ILIT). Few people realize that although life insurance proceeds are income tax free, they are still subject to estate taxes. Therefore, an ILIT is a great way to get the life insurance’s cash value out of an estate. It is best to have an ILIT be the owner and beneficiary of a life insurance policy from the start, although existing policies can often be transferred to an ILIT free of gift taxes, and they won’t be included in the insured person’s estate as long as s/he lives for at least three years after the transfer.
Perhaps the most popular form of trust is the living trust. A living trust is revocable, and therefore provides little or no asset protection. It also does not save on estate taxes. The living trust does, however, provide some privacy as well as the benefit that trust assets avoid probate. Probate is the court-appointed process of distributing a person’s wealth after s/he dies (after death, a person is referred to as the ‘decedent’.) Many people wish to avoid probate because of the following reasons:
- Probate is public and anyone can monitor a decedent’s probate proceedings, including the decedent’s creditors. Furthermore, heirs sometimes contest a will or engage in other shenanigans during probate, which a decedent might wish to avoid.
- The administrator of the estate, called the executor or (if the executor’s a she) the executrix, often charges a large amount for their services, in addition to incurring hefty legal fees that are then charged against the estate.
- Probate can take a long time, sometimes two or more years, to complete. The executor, who is often an attorney, may not be as concerned with quickly going through probate as the heirs are.