One of the primary goals of estate planning is to minimize income and estate taxes while efficiently transferring wealth to the next generation. An oft-used means of achieving this goal is the irrevocable trust, which removes transferred property from the grantor's estate. But just how safe are irrevocable trust assets?
As you may know, the irrevocable trust requires the full relinquishment and control over transferred assets. This may affect a parent's decision to put a child's inheritance in a trust, for example. What if the beneficiary is financially irresponsible or gets a divorce? Will the irrevocable nature of the trust protect those assets from creditors or an ex-spouse?
Here, we'll review these critical questions, but let's start with some basics.
Before we dive into the details, let's define some of the basic trust definitions:
Irrevocable trust: The purpose of the trust is outlined by an attorney in the trust document. Once established, an irrevocable trust usually cannot be changed. As soon as assets are transferred in, the trust becomes the asset owner.
Grantor: This individual transfers ownership of property to the trust.
Trustee: The trustee is the person or corporation charged with managing the property in the trust and carrying out its purpose and function. The trustee has a fiduciary duty to the beneficiary(ies) of the trust.
Beneficiary: The beneficiary is the person for whom the trust was created and who will receive the trust benefits.
It's important to note that trust interpretation is primarily a state law issue. As such, courts may use the trust document to evaluate whether a beneficiary has control over fund distribution. If the court determines that the beneficiary does not have control:
Trust assets cannot be considered a marital asset in a divorce.
Trust assets cannot be reachable by creditors.
On the other hand, some courts look beyond this control issue. These and other factors in the trust's design and language may further complicate this issue.
Who Has a Right to the Money?
To illustrate the complexity of trust interpretation, let's look at an example.
Jane is getting older and wants her estate plan in order. She's earmarked $1 million for her son, Jack, but she's concerned about Jack's soon-to-be ex-wife. Jane doesn't want her to have access to Jack's inheritance. Complicating the situation is the fact that Jack gambles, and Jane wants to safeguard this money from potential creditors.
Jane transfers $1 million to an irrevocable trust for Jack. Since the trust owns the assets, Jane believes neither Jack's ex-spouse nor his creditors will have access to the money.
Here, the court must determine whether the trust assets can be considered in the division of assets in the divorce. Several creditors also want access to the assets. So, who has a right to the money?
Jane. From Jane's perspective, neither Jack's soon-to-be ex-spouse nor his creditors are entitled to the money.
This was her money, which she put to work for a specific purpose.
Jane put the money in a trust, rather than giving it directly to Jack.
The assets were never in Jack's possession, so they should not be considered his property for purposes of divorce or debt.
Divorcing spouse. The divorcing spouse also has a compelling argument for why the assets should be considered.
If the money in trust is the only substantial marital asset, she might argue that it's fair and equitable to consider this money in the divorce.
She could also argue that Jack's rights under the trust should bring the assets into consideration.
Creditors. Here, the argument focuses on control and access.
Jack's right to demand property at certain intervals may be strong enough, in the court's view, to merit inclusion.
If mandatory income provisions force the trustee to distribute income to Jack, little creditor protection may be afforded.
Creditors can argue that powers of appointment strengthen Jack's ownership interest to a level that makes trust assets reachable.
How to Protect Trust Assets
Given these arguments, how can a grantor mitigate the risk that unwanted parties will gain access to irrevocable trust assets? Ultimately, protecting those assets is the estate planning attorney's responsibility. But your clients' knowledge of the following provisions may help protect the assets they hope to transfer to heirs.
Powers of appointment. These provisions allow the beneficiary to name new beneficiaries to his or her share of the assets. In general, the greater the powers of appointment, the higher the risk that trust assets will be exposed.
Powers of appointment can potentially expose trust assets to a divorce proceeding or creditors.
The courts differ in how they view this issue, so it is an important factor in trust design.
Beneficiary as trustee. It's not uncommon for a grantor to name the beneficiary as the trustee. By doing so, assets become vulnerable to divorce agreements and debt settlements.
If the trustee has discretion to make distributions to the beneficiary (himself or herself), it could be difficult to argue that this is not outright ownership.
If the intention of the trust is to create a platform for asset management, naming the beneficiary as trustee may make sense.
The grantor should understand that this structure is almost certain to expose trust assets to the same risks as those to the beneficiary's personal property.
Control. In Caruso v. Caruso, the beneficiary's relationship to his trustee (the beneficiary's accountant) was considered.
The trustee had full discretionary power to distribute assets to the beneficiary.
The beneficiary—who had no powers under the trust—argued that trust assets should not be considered in his divorce.
The court determined that the accountant was the beneficiary's "yes man" and was too close to exercise independent judgment.
The relationship between the trustee and beneficiary can be a weak point. Often, a family member or friend is chosen. But if this person is too close to the beneficiary or will have trouble acting independently, he or she may not be the best choice.
Mandatory income. There are infinite ways to write a trust, depending on the grantor's goals.
Trusts often include a mandatory provision directing the trustee to pay income and/or principal to the beneficiary.
In some cases, trustees have discretion to distribute income and principal according to the ascertainable standard (health, education, maintenance, and expenses).
Some state courts have considered the mandatory income payment as a marital asset, while others have not. If asset protection is a concern, the grantor should consider whether a mandatory income option is the best choice. Giving the trustee discretionary power to distribute income and principal may be a better option for asset protection.
Understanding the Risks Is the Best Preparation
As a financial advisor, you must be careful not to give legal or tax advice when helping in the development of your clients' estate plans. But by understanding how trusts work—and their risks—you can prepare your clients with appropriate questions for their attorneys. And remember this: just as you're not in a position to give legal advice, most attorneys won't understand your client's entire financial picture. Combining your specific expertise can bring tremendous value, helping your clients meet their estate planning goals and transfer their wealth as intended.
Editor's Note: This post was originally published in May 2015, but we've updated it to bring you more relevant and timely information.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
This material is for educational purposes only and is not intended to provide specific advice.