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Asset Protection Trusts

Property insurance and security concept. Protecting gesture of man and house model. Investment in real estate.

You’ve worked hard to build a nest egg for retirement and to pass on a legacy to your children or other beneficiaries. The recipients did not have to earn the money they will inherit so how do you know if your children will be able to effectively manage money that essentially falls into their laps?

This is an estate planner’s concern and a client’s dilemma. How do you ensure hard-earned money isn’t squandered when you pass away or obtained by a third-party? Particularly for clients with younger children, how do you know if those children have the requisite maturity and financial literacy? What about potential adverse judgments, divorcing spouses or other creditors? An asset protection trust created under your own trust or by your last will and testament may be best practice.

What Is An Asset Protection Trust?

When giving assets to children (or other beneficiaries), there is a natural tension between giving outright gifts to promote maximum flexibility and providing those gifts in trust for asset protection.  A common estate planning tool for a married couple is the creation of a joint or two revocable living trusts, which, upon the death of the first spouse, directs all assets to the surviving spouse (if not married or if the spouse predeceases) and then to the children through asset protection subtrusts created under the revocable living trust. This subtrust for the children is only established and funded upon the surviving spouse’s death at which point it becomes irrevocable. If the original trust is drafted properly and includes a spendthrift clause, a child’s interest cannot be assigned for the benefit of a creditor or a divorcing spouse, or be used to satisfy an adverse judgment. This is how the subtrust earns its name as an asset protection trust. Assuming all trust formalities are observed, a child can still be the trustee of his or her own asset protection trust.

When Is An Asset Protection Trust Appropriate or Necessary?

Estate planning doesn’t assume you will live a long life; rather, it assumes you will die after you’ve signed your documents and the moment you walk out of the estate planner’s office. Estate planning contemplates the worst case scenario. Unless you are sufficiently aged such that you have a clear understanding of how your children manage money, the stability of their romantic relationship, and their exposure to potential lawsuits, this risk is endemic to any estate plan. If you have adult children in their 50s who work in a non-professional field with limited exposure to liability and who are in stable, long-term marriages with children of their own, you may have a clear understanding about your children’s financial competency. For clients in situations such as these, asset protection subtrusts may not be worth the added expense and the trust can be drafted to distribute gifts directly to these children.

What about the worst case scenario for clients in their 20s, 30s, or even 40s? A younger married couple with young children will likely not be graced with the same knowledge and understanding as the couple with adult children. In fact, it is nearly impossible to forecast who the children will marry, what type of job they will have, or whether they will be financially literate. This illustrates the importance of having asset protection trusts serve as the default in the underlying document, only changing gifts when clients are confident in their children’s abilities.

Spendthrift Clauses and Distribution Standards

Thus, an asset protection trust with a spendthrift clause is an essential and indispensable component of plans for clients with young children or with irresponsible adult children. A spendthrift clause prohibits the child from alienating his or her interest in the trust for the benefit of creditors or other specified persons. Illinois has held that these clauses are enforceable and are not void as against public policy. Illinois also provides that these monies are protected against adverse judgments where the trust was created by someone other than the judgment debtor. There are a few exceptions where the debtor has a judgment for child support obligations, persons who provided services for the protection of the child’s interest in the trust, and claims by the State of Illinois or the United States. The child’s interest in the trust is also exempt from bankruptcy except where the child was given too much discretion to spend trust assets for his or her own benefit. Yet still, a child can be the trustee of his or her own asset protection trust, but the formalities must be observed and the distribution standard must be narrow.

A discretionary standard affords the greatest creditor protection because it gives the trustee unfettered discretion to make distributions for the child’s interest. If the child intends to also be trustee, however, a discretionary standard may open an unwanted door for creditors. A support standard is more common and ensures, in part, that the trustee will, in fact, make distributions to the child. This is the typical “HEMS” ascertainable standard, which allows the trustee to make distributions for the beneficiary’s health, education, maintenance in reasonable comfort, and support. In this way, a child could also be trustee and ensure that some distributions may be made while still maintaining some measure of creditor protection. Regardless of the specific standard, it is preferable from a creditor-protection standpoint that the trustee refrain from creating or requiring a consistent pattern of distributions to the child.

This illustrates the importance of including clear and consistent provisions for distributions of income and principal. It is worth reiterating that, regardless of the standard, mandatory or set periodic payments diminish the creditor protections of the trust. In an effort to keep these benefits firmly intact, it may be worth adding a provision that requires all distributions be stopped in the event of a child’s reckless or irresponsible behavior. This could include being named as a defendant in a civil, criminal, or bankruptcy proceeding, substance abuse, divorce or paternity actions, deprivation of beneficiary’s enjoyment (change in country of residence, affiliations with certain groups, voluntary or involuntary commitment, incarceration, etc.), military duty,  or other changes in circumstances in the trustee’s discretion. It may be prudent to avoid mandatory distributions or withdrawal rights all together.  Finally, it would also be wise to strike any power of appointment to eliminate the appearance of control or direction over the trust assets.

If the grantor does intend for a child to act as trustee, the trust should provide that distributions to the child must be limited to an ascertainable standard. This restriction is necessary to avoid (1) a taxable gift under 26 C.F.R. §25.2511-1(g)(2) or (2) the creation of a general power of appointment, which would result in the inclusion of trust assets in the beneficiary’s estate under §2041 of the Internal Revenue Code, 26 U.S.C. §2041.[1]

This illustrates the importance of careful drafting of the administrative provisions of the trust. This is where the draftsman can clearly state that no distribution may be made that would satisfy an obligation of support of the child. In addition, it may be wise to include a statement in the administrative provisions that limit a beneficiary’s right to make distributions for any purpose other than an ascertainable standard as a precaution if a beneficiary becomes a trustee at any point in time.

There is an inherent conflict between providing trust beneficiaries with flexibility and protecting trust assets. If the grantor’s primary objectives is the latter, an asset protection trust can provide tremendous insurance against adverse judgments, creditors, divorcing spouses, and bankruptcy. There are a few limited exceptions, but these devices can help retain monies in trust for future generations subject to the immediate needs of current beneficiaries.

[1] Asset Protection Planning 2018 Edition, Illinois Institute of Continuing Legal Education, Chapter 6: Drafting Considerations for Trusts, written by Sheri E. Warsh, as revised and rewritten by Brian M. Bentrup and Alfred S. Lee (new publication expected late 2021).

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