One goal of estate planning is minimizing income and estate taxes while transferring wealth to the next generation in the most efficient way possible. A trust is one method for achieving this goal. The irrevocable trust, in particular, is a popular option because it removes transferred property from the grantor's estate. But many of your clients may be asking, how safe are irrevocable trust assets?
In fact, 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. 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?
Let's review these critical questions, as overlooking them could lead to unintended consequences.
Whether a trust is in place or simply being considered, your clients should understand when assets could be exposed to risk—and how to mitigate that risk. Step one is educating your clients about the main parties to a trust:
- Irrevocable trust: This trust cannot be changed once established. An attorney outlines the purpose of the trust in the trust document. Once assets are transferred in, the trust becomes the asset owner.
- Grantor: The individual who transfers ownership of property to the trust.
- Trustee: 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, not to the grantor or other party.
- Beneficiary: The person for whom the trust was created and who will receive the trust benefits.
To get back to our question (how safe are irrevocable trust assets?), 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. That's not necessarily true, however.
A Matter of Interpretation
Trust interpretation is primarily a state law issue, so outcomes can differ depending on jurisdiction. Courts may use the trust document to evaluate whether the 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 further complicate this issue.
Making the Case
Getting back to our example, 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. Who has a right to the money?
Jane's argument. 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.
- Instead of giving the money directly to Jack, she put it in a trust.
- Because the assets were never in Jack's possession, they should not be considered his property for purposes of divorce or debt.
Divorcing spouse's argument. The divorcing spouse 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 may also argue that Jack's rights under the trust should bring the assets into consideration.
Creditor's argument. The creditor's 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.
Protecting Trust Assets
Given the validity of these arguments, how can a grantor mitigate the risk that unwanted parties will gain access to irrevocable trust assets? Ultimately, protecting trust 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.
- Powers of appointment can potentially expose trust assets to a divorce proceeding or creditors.
- The courts differ in how they view this issue, so this is an important factor when designing the trust.
- In general, the greater the powers of appointment, the higher the risk that trust assets will be exposed.
Beneficiary as trustee. It's not uncommon for a grantor to name the beneficiary as the trustee of the trust. 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. A recent case investigated the beneficiary's relationship to his trustee (the beneficiary's accountant).
- 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.
Helping clients with estate planning must be done with care. As a financial advisor, you must be careful not to give legal or tax advice. Still, by understanding how trusts work—and their risks—you can help prepare your clients with appropriate questions for their attorneys. And 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 transfer their wealth as intended.
What other factors should your clients consider before using an irrevocable trust? Have you partnered with attorneys to successfully implement a trust? Share your thoughts with us below.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.