In Part One we ended talking about Revocable Family Trusts and what they are. Continuing that conversation, the next step is…

Asset Protection for Trust Beneficiaries
A revocable trust provides no asset protection for the trust maker during his or her life. Upon the death of the trust maker, however, or upon the death of the first spouse to die if it is a joint trust, the trust becomes irrevocable as to the deceased trust maker’s property and can provide asset protection for the beneficiaries, with two important caveats.

First, the assets must remain in the trust to provide ongoing asset protection. In other words, once the trustee distributes the assets to a beneficiary, those assets are no longer protected and can be attached by that beneficiary’s creditors. If the beneficiary is married, the distributed assets may also be subject to the spouse’s creditor(s), or they may be available to the former spouse upon divorce.

The second caveat follows logically from the first: the more rights the beneficiary has with respect to trust distributions, the less asset protection the trust provides. Generally, a creditor “steps into the shoes” of the debtor and can exercise any rights of the debtor. Thus, if a beneficiary has the right to compel a distribution from a trust, so too can a creditor compel a distribution from that trust.

Therefore, where asset protection is a significant concern for the client, it is important that the trust maker not give the beneficiary the right to automatic distributions (for example, 5% or $5,000 annually). A creditor will simply salivate in anticipation of each distribution. Instead, the client should consider discretionary distributions by an independent trustee.

Lastly, with divorce rates at or exceeding 50% nationally, the likelihood of a client’s child becoming divorced is quite high. By keeping assets in trust, the trust maker can ensure that the trust assets do not go to a former son-in-law or daughter-in-law, or their bloodline.

Irrevocable Life Insurance Trusts
With the exception of the self-settled spendthrift trusts discussed above, a transfer to an irrevocable trust can protect the assets from creditors only if the trust maker is not a beneficiary of the trust. One of the most common types of irrevocable trust is the irrevocable life insurance trust, also known as a Wealth Replacement Trust.

Under the laws of many states, creditors can access the cash value of life insurance. But even if state law protects the cash value from creditors, at death, the death proceeds of life insurance owned by your clients are includible in their gross estate for estate tax purposes. Clients can avoid both of these adverse results by having an irrevocable life insurance trust own the insurance policy and also be its beneficiary. The dispositive provisions of this trust typically mirror the provisions of the client’s revocable living trust or will. And while this trust is irrevocable, as with any irrevocable trust, the trust terms can grant an independent trust protector significant flexibility to modify the terms of the trust to account for unanticipated future developments.

If the trust maker is concerned about accessing the cash value of the insurance during lifetime, the trust can give the trustee the power to make loans to the trust maker during lifetime or the power to make distributions to the trust maker’s spouse during the spouse’s lifetime. Even with these provisions, the life insurance proceeds will not be included in the trust maker’s estate for estate tax purposes.

Irrevocable life insurance trusts can be individual trusts (which typically own an individual policy on the trust maker’s life) or they can be joint trusts created by a husband and wife (which typically own a survivorship policy on both lives).

Conclusion
Clients can protect their assets from creditors by placing them in a well-drafted trust, and they can protect their beneficiaries from claims or creditors and predators (former spouses) by keeping those assets in trust over the beneficiary’s lifetime. By working together, the wealth planning team can ensure that the plan meets each client’s unique planning objectives.

(As before, my thanks to Richard M. White, Esq., for providing me with the necessary tools to extend this conversation. Look for Part III in the next several days.)