Using Third-Party Trusts for Asset Protection

 In Asset Protection

I recently had an inquiry from a prospective client who was wondering whether his son who is engaged to be married to could protect his assets in the event of divorce. Apparently, a prenuptial agreement is out of the question. I responded that it’s difficult for his son to protect his own assets (which is explained here), but that it’s a lot easier for the father to protect whatever he leaves his son.

The common law has always permitted donors to create trusts for others that would not be subject to the beneficiary’s creditors. These are often called “spendthrift” trusts because they are designed to protect beneficiaries’ from their own bad decisions, as well as to keep funds in the family. To work, the trust must be discretionary, meaning that the trustee has full authority to determine when, whether and how to make distributions to beneficiaries directly or on their behalf, and it must contain language barring beneficiaries from pledging or conveying their interest in the trust. With those provisions, the trusts are protected from the beneficiaries’ creditors. But, the result is that they can be very restrictive. There’s an apocryphal story about how restrictive they can be:

A young Harvard student goes in to the Boston business district to meet with the gray-haired trustee of his trust to ask for money to buy a new suit. This, of course, was back in the days when Harvard students wore suits. The trustee responds: “When I was at Harvard, I had one suit that lasted me all four years.” Before continuing, he pauses to pick some lint off of his sleeve. “In fact, it’s still standing up pretty well today.”

Not surprisingly, the Harvard student’s request for funds to buy a new suit was denied. One moral of the story is that when planning your estate and the protections you want to provide your heirs, the more protective a trust is, the more restrictive it is as well. A second moral of the story is to pick your trustee well. The trustee in this case may or may not have been carrying out the wishes of the person who created the trust. In other words, he may have been applying his own frugal values rather than those of the trust creator.

Family Protection Trusts

In our practice, we often prepare for our clients what we call “family protection” trusts (borrowing the name from my colleague Michael Gilfix of Gilfix & Associates in Palo Alto, California). In attempt to balance protection with practicality, we typically design the trusts as follows:

  1. We create a separate trust for each beneficiary.
  2. The beneficiary (usually a child) may serve as trustee and even as the only trustee.
  3. But while she may manage and invest the trust funds as he sees fit, she may only distribute income to herself.
  4. If she needs access to principal, she must appoint an independent trustee who would have discretion to distribute principal for her benefit or refuse to do so.

This trust design is meant to provide protection while responding to the reluctance of many clients (and their children) to give up control. It will work as long as the child actually follows the rules of the trust. Its great Achilles heel is that the beneficiary has access to the trust property and could easily drain the trust. This would violate the terms of the trust and make him liable to a claim by the remainder beneficiaries. But they are likely to be his children or siblings and would probably be unlikely to sue him. In addition, if he’s the type of person who would drain the trust he also may be likely to spend the trust assets and not have other assets available to pay the resulting judgment won by his chidren. Even if the beneficiary trustee does not completely drain the trust, but starts spending some of the principal, he will undermine its protection, making it more vulnerable in lawsuits by creditors or a spouse. This means that the trustee needs careful instruction when the family protection trust is funded. Appointing an independent trustee from the outset is definitely more secure. Unfortunately, many clients sacrifice safety in the interest of avoiding payment of professional trustee fees.

So, in determining whether to create a family protection trust and whether to name a family member or an independent trustee, you will need to balance your children and grandchildren’s need for protection and their likely level of responsibility. While bad things, financial and otherwise, can happen to anyone, those most likely need protection may also be more likely to need an independent trustee.

Tax Protections

In addition to creditor and divorce protection, family protection trusts also offer tax protection since the funds in the trust will not be included in the child’s taxable estate. For this reason, they are sometimes referred to as “generation skipping” trusts, since the ultimate distribution goes to the grandchildren, skipping the children. Because a lot of rich families were using these trusts to avoid taxation at the passing of each generation, allowing accumulated wealth to continue potentially for centuries, Congress enacted a generation skipping tax. This gets very complicated, but the bottom line is that it limits how much can pass tax free from generation to generation.

Keeping It in the Family

For the less wealthy, family protection trusts also keep assets in the family in the event of the premature death of a child. If a child directly inherits funds and then passes away, they will likely pass to her spouse. The spouse may get remarried, have additional children, and even become estranged from the children of his first marriage (we have seen this happen). Those children may then receive none of the property that came from their grandparents. If, instead, the grandparents had left the funds in a family protection trust, at the death of the parent they would remain in trust for the benefit of her children.

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