Trusts can be very effective creditor protection tools. We use them all the time for this purpose. However, there is one trust, that although it can provide fabulous creditor protection for other trust beneficiaries, it does not provide any creditor protection for the trustmaker’s debts during the trustmaker’s lifetime. This trust is the most common trust that we see coming into our office. It makes up 95+% of the trusts we draft in our practice. It is the revocable living trust.
Most of our clients, before coming to see us, believe that their creditors could not touch the assets that they put into their revocable living trust. They thought that when they had a trust and had a catastrophic creditor, such as an auto accident personal injury judgment or a defaulted mortgage loan, they could just walk away with no repercussions. They thought they were protected.
If they would have had a catastrophic creditor before coming to us, it would have been, as Gomer Pyle used to say, “Surprise! Surprise! Surprise!” With the exception of certain retirement plans and entireties property, virtually every one of the trustmaker’s assets that were either inside or outside their trust would have been accessible by the trustmaker’s creditors to pay the trustmaker’s debts.
If you have a revocable living trust, it generally does not become permanent until after your mental disability or your death. During your lifetime, it is fully changeable. As legal and life changes occur, you can amend it at any time or even revoke it. While you are alive and well, you have full access to all of the assets in your trust. You can put stuff in and take stuff out.
However, since you have full access to all of the assets in your trust during your lifetime, so do your creditors. If you have a catastrophic creditor who gets a judgment against you, they can take every single asset in your trust.
This is especially problematic with spousal joint trusts. Most estate planners are estate tax driven. You will be told that you should have a joint trust because you do not have a taxable estate. Because of the 2013 increase in the estate tax exemption amount to $5 million ($10 million for 2018-2025) indexed to inflation and the “portability” of the exemption between spouses, most traditional planners are drafting joint trusts. The exemption is now $11.2 million in 2018. We have new clients coming into our office all the time with existing joint trusts.
What these couples with joint trusts are never told until they meet with us, is that while both of them are living, 100% of the assets in the joint trust are accessible by a catastrophic creditor of either spouse. And after the death of one of them, the survivor generally has full access to the assets of the formerly joint trust, making 100% of the assets in the trust accessible by a catastrophic creditor of not only the survivor, but also of the deceased.
Although taxes may be an important component of an estate plan, in our office, taxes are rarely the primary focus of a plan. Because of this, once we explain all the benefits and burdens of joint trusts versus separate trusts, most of our married clients choose spousal separate trusts.
With a separate trust for each spouse and about one-half of the marital assets allocated and funded into each of your trusts, you can insulate marital assets from the creditors of each other. Trust funding is completely and correctly designating your trust and individuals as owners, beneficiaries and insured parties of your assets. Basically, it’s putting your stuff in your trust. The entire marital estate would no longer be at risk. A catastrophic creditor of either of you could only access the assets in one spouse’s trust, which protects the other half of the marital assets in the other spouse’s trust.
Similarly after the death of one spouse. With properly drafted and funded separate trusts, you can insulate marital assets in the deceased’s spouse’s trust from the creditors of the surviving spouse. When you properly draft and fund these separate trusts, each of you would provide a lifetime trust for the surviving spouse. The surviving spouse would have full access to the deceased spouse’s trust assets for any needs, for their lifetime. However, the assets in the deceased spouse’s separate trust are protected from the surviving spouse’s creditors.
For example, if the survivor gets sued and has a huge judgment entered against them, the survivor could lose everything individually owned by the survivor and in the survivor’s separate trust. However, in such case, although the survivor still has full access to the assets in the deceased spouse’s separate trust for any needs, the survivor’s creditors cannot touch any of those assets in the deceased spouse’s separate trust. In addition to creditor protection, with separate trusts you can also include remarriage protection, in case your surviving spouse remarries Thor, her Swedish personal trainer, or Bambi, his aerobics instructor.
Creditor protections can continue in place for non-spouse beneficiaries. Most of our trust clients also provide lifetime trusts for their non-spouse beneficiaries’ inheritances. With properly drafted and funded lifetime trusts for your beneficiaries, your beneficiaries will have full access to the inheritance for their needs, but no one else can. If your beneficiary gets sued, creditors can’t touch any of the assets in the lifetime trust.
In addition to creditor protection, there are many protections and benefits of trusts that are not available with a will, joint ownership or beneficiary designations. They include privacy, probate avoidance, and protections for minors, young adults, beneficiary divorce, lazy beneficiaries, mentally disabled beneficiaries, addicted beneficiaries, the family cottage, family pets and higher education funding.
You can protect your assets from your creditors during your lifetime with a trust. However this trust is not a revocable living trust, it is an irrevocable trust. With this irrevocable trust, if certain legal requirements are met, you can shield your assets from your creditors during your lifetime and after your death. You will need to set up a Michigan trust with a Michigan trustee other than yourself and keep the assets in Michigan. This trust is commonly called a domestic asset protection trust.
Once properly established and assets are properly transferred to this irrevocable trust, your creditors generally cannot reach your assets after they have been in the trust for at least two years. For bankruptcy or fraud, a longer statute of limitations may apply.
This irrevocable domestic asset protection trust may be used in addition to or as an alternative to a prenuptial agreement. If you are getting married and want to protect your assets, you do not need consent from your future spouse and do not need to tell them what assets you own, as is required with a pre-nuptial agreement. The property in this irrevocable trust is not considered marital property, directly or indirectly, so long as the property is either transferred to the trust more than 30 days before marriage, or your new spouse consents.
If you are married, during your lifetime, you can have creditor protection for part of the marital estate using spousal separate revocable living trusts. After your death, you can continue creditor protection for your beneficiaries, including a surviving spouse, by including lifetime trusts for your beneficiaries in your revocable living trust. And if you do not mind giving up control of your assets during your lifetime, you can protect your assets from your own creditors by using an irrevocable domestic asset protection trust.
By Matthew M. Wallace, CPA, JD
Published edited March 4, 2018 in The Times Herald newspaper Port Huron, Michigan as: Trusts don’t automatically deny creditors