Asset Protection and Self-Settled Trusts: Having Your Cake and Eating it Too
The rule under traditional, or “common-law,” trust law is that you cannot be a beneficiary of a trust you create yourself and protect the property from your creditors. You can, however, create a trust for someone else – often called a “third-party” trust—and write it in such a way that it will be protected from her creditors. However, there are three ways around this rule precluding asset protection for self-settled trusts for your own benefit.
The first is to create an irrevocable trust that restricts your access. For instance, you can create a trust that pays out the interest, dividends, or rental income to you, but which completely restricts your access to principal. In essence, you’re giving up your access to trust property in exchange for protection of that property. These trusts are often used in the context of planning for Medicaid coverage of nursing home care. You might also title real estate in such a trust preserving only the right to use and occupy the property. In any of these trusts, beware of the tax consequences and the differing state rules on “Medicaid-qualifying” trusts.
The second option is to create a trust for the benefit of a third party, such as a spouse or child who you want to provide for or who could share the trust benefit with you if necessary, though they’re not legally required to do so. This is really a third-party trust — one you create for someone other than yourself — but one which carries out a goal or goals on which you may normally spend funds. This may be easier with a spouse, since if the trust, for instance, pays all housing costs for your spouse and you happen to live in the house as well, you will still reap a benefit. If, on the other hand, a child funnels trust distributions back to you, the trust may be treated as a sham since you may be deemed as the true beneficiary. So, if you’re transferring your own funds into a trust for asset-protection purposes be sure that you’re ready to give up access to such property.
Hybrids of the first two approaches may also be available. For instance, you may create a trust that permits distributions of income to you and principal to your children and grandchildren.
Domestic Asset Protection Trusts (DAPTs)
The third option is to take advantage of the laws in those states which have overturned the “common law” and permitted the creation of self-settled asset protection trusts, so-called domestic asset protection trusts or DAPTs (as opposed to off-shore trusts). Led by Delaware, Alaska, Nevada and South Dakota, 12 states (Alaska, Colorado, Delaware, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah and Wyoming) now permit such trusts. Each state has its own rules, but typically they require that the trust property be held in a financial institution in its state and that at least one trustee – whether institutional or individual – be from that state. While you cannot serve as trustee, you can appoint someone you trust – perhaps your lawyer or accountant or a close family member – to serve as “trust protector” to have certain rights, such as the ability to change trustees, amend the trust as needed to comply with changes in the law, or even to change beneficiaries.
So far, there have been few cases actually testing these DAPTs and statutes. Their proponents argue that even where the trusts might be challenged, such challenges would be litigated and at the very least the cost and uncertainty of such litigation would serve as a hurdle to recovery, thus making a favorable settlement of a claim much more likely. At best, the trusts totally protect the assets they hold from creditors. Since these trusts are somewhat expensive to set up and administer (and potentially to defend in court), they are generally used by people of high net worth in potentially risky businesses – such as medical professionals who may be sued for malpractice. If you would be interested in pursuing an out-of-state asset protection trust, you will need to consult with a specialist in the field. Be aware that the fraudulent conveyance rules apply to these trusts, meaning that you cannot use them protect assets from claims that already exist, just from potential future claims.