Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

PROTECTING YOUR ASSETS WITH A CREDIT SHELTER TRUST
(2/17/02)

If you are like many of my estate planning clients, you have established a trust for several reasons. The first is your desire to control your property while facilitating the transfer of control of it if you become disabled or at your death. Second, especially if you own property in several different states, you hope to avoid the expense and time involved in probate. Finally, you want to ensure the property you leave to your beneficiaries is protected against outside claims. Today, I would like to focus on the last of these.

How Does A Trust Protect Property And Assets?

The simple answer is, if you don't own something, nobody can take it away from you. Much of the asset protection planning we do involves an older client, normally a parent, leaving property to a younger beneficiary. The client wants to leave the property to the beneficiary in trust so the beneficiary's creditors, divorcing spouse, or others cannot reach the assets. This is true whether we are using a credit shelter trust or a special needs trust for a disabled beneficiary.

So How Does This Work?

Well, the first creditor we want to avoid paying is the Internal Revenue Service. Let's say you and your spouse are each worth $1 million. If you, as the husband, die and leave your estate to your spouse, her estate will be worth $2 million. If she dies in 2002, her estate will be subject to significant state and federal estate taxes.

To avoid the imposition of estate tax, you should leave your estate to a credit shelter or family trust for the benefit of your spouse. Even though the income and some or all of the principal of the family trust is available to your surviving spouse, she doesn't own it so the IRS cannot tax it.

Is There Any Risk To Leaving My Property To A Family Trust?

If the family trust is not properly designed, its assets could be at risk. If your surviving spouse is given too great control over the assets in the family trust, a court could allow a creditor to reach these assets.

How Does This Work?

Let's assume you leave your $1 million to a family trust. One day your widow leaves the back fence unlocked and a neighbor child wanders into your pool and drowns. The child's parents sue for negligence and the court rules in their favor. The parents clearly can reach your widow's assets. The question is: Can they reach the $1 million in the family trust?

How Does The Court Decide Whether The Child's Parents Can Reach This Money?

The Judge will look at your widow's power over the property in the family trust. That is, does she have enough control over the trust to be considered its owner? There are a number of factors the court will look at in answering this question:

Is your widow the only trustee? A trustee has a fiduciary obligation to the beneficiaries of the trust. Let's assume your three children are the residual beneficiaries of the family trust. Your widow must protect the assets in the family trust for your children's benefit. It doesn't matter that she is your surviving spouse and entitled to benefit from the trust. She is still stopped from taking any action which would be detrimental to your children's interests.

Is your widow the sole beneficiary, as well as the trustee? If you didn't have any children, this would complicate the situation. If your widow is both the beneficiary and the person making the decisions as trustee, she begins to look very much like the owner of the family trust and the court could well make the assets of the trust available to the child's parents in settlement of their lawsuit. To avoid this situation, you should consider having someone else serve as the trustee or at least appointing a co-trustee to serve with your widow.

In the past, where the children are the remainder beneficiaries of a family trust, the xourts generally have held that the assets of the family trust are protected. Don't consider this a guarantee, however, because courts have become more lenient toward creditor rights in the past few years and the costs of defending against creditor claims can be very high.

Is There A Way To Avoid This Problem?

There are several things you can do. First, appoint a co-trustee who will agree on any distributions to the surviving spouse.

Next, designate more than one current income beneficiary of the family trust. For example, in addition to your surviving spouse, you might allow payments to be made to one or more of your children for educational or other purposes.

Don't give your surviving spouse the right to remove the co-trustee other than for just cause.

Finally, if you want to be sure the family trust assets are safe from creditors of your surviving spouse, appoint an independent trustee (or co-trustees) other than your spouse. That way, she has no control over the assets and it will be far more difficult for a creditor to reach them.

I'm Not Sure My Wife Would Like These Restrictions.

That is a problem we always have to discuss with our clients. Usually, the surviving spouse wants complete access to all the estate assets. If you both agree that you are willing to risk the assets being reached by creditors, that's fine. All we can do is identify the problems and the issues. The final decision is up to the clients.

Nothing is absolute. Even with the best safeguards, a court can still penetrate a trust for the benefit of a creditor. All you can do is seek the advice of a competent professional, arrange your affairs accordingly, and hope it dissuades a creditor from making the attempt.

To return to the Strategic Planning Articles click here.