Asset Protecting Your Child’s Inheritance

For some reason there seems to be a little known fact that you can “asset protect” the inheritance you leave to your children in your revocable trust. There are two basic considerations to obtaining the asset protection. The first consideration is to make sure the children do not have a demand right to the assets in their respective continuing trusts. The second is the placement of an independent discretionary trustee over each continuing trust.

To address the first consideration, what does it mean to have no demand right? A demand right is much like it sounds. An example would be: “Little Johnny, upon reaching age 25, has a right to 50% of the assets in his trust.” This means that once Johnny reaches 25, he may “demand” from the Trustee up to 50% of the assets in his continuing trust. On the surface this may not sound like a bad thing. However, when we dig deeper, you will see the problems that could and do arise with this type of arrangement in the trust document.

Let’s say that little Johnny got married at age 21. Unfortunately, 5 years into the marriage the couple realizes that they are not a perfect match. In fact they come to absolutely hate one another. The soon-to-be ex-wife is bent on taking him to the cleaners because of course she believes everything that’s wrong with the marriage is all Johnny’s fault. Even though Johnny had the right to withdraw up to 50% of the assets in his trust when he turned 25, he made no withdrawals. He continued to let his Uncle Ron manage the 50% that he could have demanded from Uncle Ron, the Trustee.

Here is where it gets interesting. You will see how the first point of the demand right interacts with the type of Trustee that is serving for the trust. Because Uncle Ron is an “interested” Trustee under the IRS code (IRC 673(c)), he must make distributions to Johnny for “health, education, maintenance or support”. This is primarily because Uncle Ron is a sibling of the Grantors of the Trust. The danger is that a creditor (here the angry divorcing spouse) could try to step into Johnny’s shoes and demand money from Johnny’s trust, arguing that the distribution for alimony or child support is a “health, education, maintenance, or support” type distribution that an “interested” trustee must make.

This problem could have been averted right out of the gate by having an independent “discretionary” trustee designated in the trust document by little Johnny’s parents. The reason is because an independent trustee can make distributions based on their discretion. They can turn the faucet on or off for any reason. This puts a lot of power in the hands of the trustee but also provides a lot of protection to the beneficiary. It may also be used by the beneficiary as a bargaining chip in settlement negotiations if there is a pending lawsuit or other creditor issue.

Another circumstance where a continuing asset protection trust can literally save a child’s inheritance is when the child is involved in a lawsuit. Imagine little Johnny has been in an auto accident. His insurance company doesn’t want to settle and it is fairly clear that Johnny is at fault for the accident. If “interested” trustee Uncle Ron is still serving as trustee, it would be highly advisable that he resign as trustee immediately.

If the next named trustee to serve as trustee is an independent trustee as defined in the IRS code (IRC 673(c)), then the trustee can turn the faucet on and off at will. We call this a discretionary distribution power. The trust has to be drafted with specific language for this to properly work so that the independent discretionary trustee has the power to make distributions for any reason or for no reason (meaning they can refuse to make a distribution even if the beneficiary of the trust asks them to). This is powerful in the sense that a plaintiff going after little Johnny is going to be hard pressed to infringe on his right to any income or principle from the trust that mom and dad set up for him because the trustee can just say no.

The above scenario also provides a nice advantage to little Johnny. He can use it as a bargaining chip to negotiate with a plaintiff who has a judgment against him or one who is in settlement negotiations with him over a debt or a potential future judgment.

So the question then becomes who to list either as the primary independent trustee right out of the gate (to act as trustee once mom and dad have passed away) or as a back-up independent trustee. The options are quite broad. “Independent” trustees are those who are not directly related to or subordinate to the Grantors or the beneficiaries. “Interested” trustees generally include immediate family members and persons working for the Grantors or the beneficiaries. Some banks have trust departments or trust companies to act as current or successor independent trustee. There are private fiduciaries licensed by the state that are willing to act in this capacity. Some CPAs and attorneys are also willing to act as an independent trustee.

It is important to note that these trustees are typically paid a fee to act in this capacity. Most banks and trust companies as well as private fiduciaries have printed fee schedules that they are willing to share upfront. Most charge somewhere in the neighborhood of 1% per year of the assets under their management as trustee. Another potential choice for independent trustee could be a close family friend or even a more remote family member.

The important thing to remember is that there are many ways to structure the planning, so it is not necessarily a bad thing if you choose to nominate an immediate family member to act as successor trustee for your kids. You simply need to make them aware of the issues to look and what to do. If a child gets a divorce, has creditor issues, or a lawsuit comes about for the child, they should resign as trustee right away. Where an immediate family member (aka “interested” party) is acting as the trustee and one of these bad things happens, they simply need to sign a short document resigning as the trustee of that child’s trust. Then if there is an independent trustee next in line, you have put your shields up, so to speak. If nothing bad ever happens, then the interested family member trustee merrily goes about his or her business acting as the trustee for your child.

I also find that many of my clients want to put their children in charge of their own trusts at a certain point in time. This can also be done. For example, let’s say that mom and dad would like little Johnny to be able to take over as sole trustee of his trust at age 30. This too doesn’t have to be a bad thing from an asset protection standpoint. The key is to make sure little Johnny understands that if one of the bad things mentioned above happens, he should resign as the trustee immediately. Depending upon how the document is drafted, you can have language that allows little Johnny to pick his own independent discretionary trustee if he were to resign. He could also remove and replace that independent trustee if he later decided they were not doing a good job as the trustee.

Though there is more complexity to creating continuing asset protection trusts as a stand-alone trust or inside your revocable trust, the benefits can be enormous. Consider that if little Johnny tried to create this structure for himself in a state that allows for self-settled asset protection trusts (like Nevada, Delaware or Alaska), he’s likely going to be able to protect only up to 50% of his assets, plus have to pay a distribution trustee in the state he sets it up in on an annual basis during his lifetime. Additionally, Domestic Asset Protection Trusts are about twice cost to set up initially.

Part Two: Protecting Your Children With Lifetime Asset Protection Trusts