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THE BUILDING BLOCKS
Unfavorable Trusts
Favorable Trusts
Insurance
Divorce Protection
Exempt Assets
Equity Separation
Strategies
Qualified Plans
 
 

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  Unfavorable Trusts

 

As its name implies, a revocable trust can be revoked by the settlor during his life, in which case he will regain ownership of the trust assets. Revocable trusts have general benefits. They allow the settlor to control trust property in life and determine who receives benefits after his death. They allow orderly disposition of property after the settlor’s death, outside of probate, and they can greatly reduce the cost of probate where property is owned in multiple states. They can also allow for management of financial assets during periods in which the settlor is incapacitated.
However, the right to revoke makes these trusts less sturdy from an asset protection perspective. Many jurisdictions hold that a settlor with a right to revoke should be forced to revoke to satisfy the claims of his creditor. Additionally, if the settlor enters bankruptcy, the bankruptcy estate acquires the right to revoke. Thus, revocable trusts are of limited benefit for asset protection.
 
 
Revocable:      After the settlor transfers assets, s/he can revoke the transfer, shifting assets back into the settlor’s name.
 
Irrevocable:     Once the settlor transfers assets, the assets cannot be transferred back into the settlor’s name. The assets become the permanent property of the trust until they are distributed to the beneficiaries.
 Few situations call for revocable trusts for asset protection. If one spouse of a married couple is more at risk than the other, revocable trusts can be used to place non-exempt assets beyond the reach of the at-risk spouse’s creditors. Let’s see how this plays out in the Whitmore family.

 

Case Study
Consider again Alan Whitmore. A business owner and a land developer, Alan is constantly facing the threat of lawsuits, while his second wife, Aleksandra, is a homemaker with limited risks. Prior to working with our firm, Alan and Aleksandra created a thin layer of asset protection by taking inventory of their assets, converting marital assets into separate property, divided equally between them. Alan created the Alan Trust, a revocable trust. Aleksandra created the Aleksandra Trust, also a revocable trust. Unlike Alan’s trust, which held exempt assets that are out of the reach of creditors (assets that are given special protection by the state from creditors), Aleksandra’s trust held all non-exempt assets.
 
Each spouse then transferred his or her share of the property into his or her respective revocable trust, of which he or she is the settlor, the initial beneficiary, and the trustee. Each trust provided that the other spouse becomes the beneficiary after the settlor’s death or when they disclaim interest.

Alan and Aleksandra’s Marital Assets

 
Alan, the at-risk spouse, acts as settlor, trustee, and beneficiary on the Alan Trust, which holds the couple’s exempt assets
 

In some ways, this appears to be a savvy strategy. Because Alan is the more likely to be sued, the only assets in his revocable trust would be those exempt from creditors. Unfortunately, the plan has a few problems.
 
The couple assumed that Alan was the more likely to face a lawsuit. After all, he owned several high-risk companies while Aleksandra was a homemaker. But what happens if Aleksandra is in a car accident and severely injures another party? What if she neglects to keep on eye on the neighborhood children swimming in her pool?  If Aleksandra were to be sued, a less-probable but still possible situation, all non-exempt assets in the revocable trust would be within a creditor’s reach.
 
At the death of Aleksandra all of the assets in her trust would be transferred to Alan. If he had any judgments against him, a court could force distributions from the trust to satisfy the creditors.
And if the couple divorces, Aleksandra is left with all non-exempt liquid assets while Alan only has the exempt assets, which is not necessarily the outcome either spouse would choose.
 
Revocable trusts also offer little in the way of tax benefits. Until distributions are made to beneficiaries, tax laws do not consider the transfer into this type of trust “complete.” Instead, these are treated as part of the settlor’s estate. The settlor pays taxes on the trust’s income at the top marginal income tax rate. Unless the trust deed transitions the assets into irrevocable status, the value of the trust is included in the settlor’s estate at his death, exposing assets in the trust to estate taxes.
Alaska- and Delaware-Type Asset Protection Trusts
Alaska- and Delaware-type asset protection trusts (which are available in Nevada and Rhode Island as well) allow a settlor to benefit from his own spendthrift trust.  
Spendthrifts:   Trusts written with spendthrift provision language provide that beneficiaries cannot transfer their interest and that creditors cannot seize the beneficiaries’ future interests to satisfy claims.
The trust’s settlor or beneficiaries need not reside in Alaska, Delaware, Nevada, or Rhode Island to take advantage of the provisions offered by these trusts. However, to be effective, Alaska- and Delaware-type asset protection trust deeds should:
Contain a choice-of-law provision providing that the trust is subject to the jurisdiction of the chosen state and that state’s laws govern its validity, construction and administration.
Deposit at least part of its assets in that state and administered by an institution within that state.
Have at least part of the trust’s administration—trustee meetings, trust beneficiary meetings, initiation of trades, maintenance of accounts, and the like—occur in that state.
Be irrevocable.
Even when formed and administered correctly, several circumstances exist in which creditors can reach the beneficiary’s trust interest. Alaska- and Delaware-type asset protection trust are ineffective if:
1)   The trust deed mandates distribution to the settlor;
2)   The settlor/beneficiary owes domestic support; or
3)   The settlor/beneficiary owes a claim for bodily injury.
I once had great hopes for Alaska- and Delaware-type trusts as their protection closely resembled that of offshore trusts. Federal tax courts have also opined that transfers into self-settled, wholly discretionary, irrevocable trusts are “complete” for gift tax purposes.But when the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 became law in April 2005, the efficacy of these trusts plummeted. This legislation pierced a big hole in the asset protection offered by Alaska- and Delaware-type trusts by allowing a creditor included in a bankruptcy estate to seize assets held in these trusts if:  
The settlor becomes bankrupt and is also a beneficiary;
Assets were transferred less than ten years earlier; or
The debtor created the trust to prevent current or future creditors from collecting.
In other words, if you create a trust for your own benefit, bankruptcy creditors can seize the trust’s assets unless the assets were transferred at least ten years ago.
This legislation drastically reduces the value of Alaska- and Delaware-type trusts as asset protection tools. The Act further specifies that the provisions apply to all future creditors, not just creditors known at thetime the assets were transferred to the trust. Since no provisions allow such trusts created before the law to keep the intended protection, these trusts are rarely, if ever, recommended for clients.
IRS Private Letter Ruling 9837007 ruled that a transfer to a self-settled spendthrift trust constituted a completed gift for gift tax purposes. 
Section 548(e)(1) Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

 

 
     
 
 
 
     
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