Safeguarding
Your Family's Inheritance Against Liability Claims and Preserving an Estate in
Case of Divorce
What to Look For in Reviewing Your Estate
Planning Documents
If they give any thought to the
matter, most people would prefer to own their property in a way that they can
use, enjoy and control during their lifetime. But if they were to get divorced
(more marriages end in divorce than death), their spouse would have no claim to
their separate property. If they were to lose everything in a lawsuit, a
business failure or other misfortune, at least a portion of their property could
be protected. At their death, if they were fortunate enough to have accumulated
a taxable estate, the portion of their property that they had inherited from
their parents (which would have been taxed previously at their parents' deaths)
would not have to be taxed again before it could be left to their children,
grandchildren or others.
It is very difficult, and often impossible, for
you to achieve these benefits on your own. However, parents can provide these
benefits to their children through an irrevocable, beneficiary-controlled trust
as part of their basic estate planning with relative ease. I say relative ease
only because there are more issues to be considered when you leave property to
your children in trust rather than outright. Still more issues arise when you
leave property for benefit of your children, grand-children and future
generations in a "dynasty trust". It is well worth taking the time necessary to
do it right.
Basics of Asset Protection
If a doctor, a lawyer, or
other professional is sued, all assets that are not "asset-protected" may be
lost to satisfy the malpractice claim. If a child gets divorced, all assets
that have been treated as "marital assets" during the marriage will be subject
to division by the divorce court. At death, a surviving widow or widower has a
statutory right to file an election against the deceased spouse's estate plan to
claim his or her statutory share of the "augmented estate". In Virginia, the
augmented estate is, speaking very broadly, all assets owned by the decedent at
death, increased by gifts made during the marriage and property passing outside
of the estate, such as certain insurance and retirement plan
assets.
Assets that cannot be reached by a judgement creditor (that we
speak of as being "asset protected") include retirement plan assets held in a
"qualified plan" under ERISA; assets held by married couples as tenants by the
entirety where the claim is against only one spouse; the death benefits of a
life insurance policy; and property that is asset protected by an asset
protection trust or otherwise.
It is very difficult for an individual to
create a "self-settled" asset protection trust. Four states (Alaska, Delaware,
Nevada and Rhode Island) have legislation that permits an individual to create
an irrevocable spendthrift trust and continue to be a life-income beneficiary
and remain in control of the trust. These statutes are relatively new and have
not been tested in the courts. Many commentators question whether another state
will respect the "domestic asset protection" features of the trust where the
trust is self-settled.
In addition to self-settled domestic asset
protection trusts, it is possible to go offshore to create a foreign-domiciled
asset protection trust -- in the Cayman Islands, the Bahamas, Panama, Bermuda or
the Cook Islands, for example. Off shore trusts have a bad reputation for
money-laundering and tax evasion, as described in John Grisham's book and movie,
The Firm.
A fundamental maxim of asset protection planning is, "they
can't get what you don't own." Coughlin's corollary is, "if you own it, they
can own it."
How can you help?
1. Review your estate planning
documents -- Both Revocable & Irrevocable Trusts.
I guarantee
that if you will examine your estate planning documents, a majority of you will
find that after your death, your property is to be divided and distributed to
your children outright or, possibly in up to three installments -- typically 1/3
immediately, 1/2 of the balance five years later, and the balance ten years
later. Such property is 100 percent exposed to loss through divorce, lawsuits
and erosion from transfer taxation. To help you in your review, consider the
following:
How Have You Provided for your Surviving Spouse?
Have
you funded for the "Family Trust" or the "Marital Trust" first? In most first
marriages, I prefer to fill up the Family Trust first, since this trust is
capable of substantial asset protection planning. In smaller estates, this
means that the surviving spouse may not receive any assets under the marital
deduction because all the decedent's assets pass to the Family Trust. This
requires extreme care in drafting the trust provisions for the surviving
spouse.
If assets are first funded to the Family Trust (also sometimes
referred to as the "Credit Shelter", "Bypass" or "Unified Credit" Trust), with
any excess going to the marital trust, see if all income is required to be paid
from the Family Trust at least annually. Any income that is required to be paid
to the surviving spouse is subject to attachment by the spouse's creditors.
See if you grant your spouse a discretionary right to request the
greater of $5,000 or five percent of the trust corpus each year. This very
common "5 x 5 power" flexibility insures that five percent of the trust property
can be attached by creditors each year. Thus, over 20 years, the entire trust
corpus could be depleted. In addition, at your spouse's death, five percent of
the trust corpus that should have escaped estate taxes will be subject to estate
taxes -- again!
(Different tax rules apply to the "Marital Trust" -- the
portion of your property that is not taxed until your spouse's death. The
Marital Trust -- whether it be property that is left in a "general power of
appointment" trust or in a "QTIP" trust -- must pay 100 percent of its net
income to the surviving spouse at least annually to qualify for the unlimited
marital deduction at the first death.)
How Have You Provided For Your
Children?
Review how your property is left to your children. Is it left
outright? If so, it is 100 percent exposed to loss through divorce, lawsuits
and to erosion by transfer taxes.
Is property left in trust to your
children? If so, what are the trust's terms for distribution? Outright? In
three installments? Retained in trust for life? If retained in trust for life,
is the trust "discretionary" for the convenience of the beneficiary or is it an
irrevocable trust? If it's discretionary for convenience of the beneficiary,
the trust may afford a measure of protection in case of divorce. (Property that
is always maintained as a spouse's separate property is generally not treated as
a marital asset on divorce.)
If the trust is irrevocable, is all net
income required to be paid out to your children? If so, the trust income is
subject to attachment by creditors, reachable in a divorce settlement, and
subject to erosion by transfer taxes. Is the child entitled to a discretionary
right to request the greater of $5,000 or five percent of the trust corpus each
year. Again, over 20 years, the entire trust corpus could be
depleted.
How Have You Provided For Your Grandchildren?
If the
trust is irrevocable, what happens on your child's death? If your trust
provides that property passes to your grandchildren, make sure the trust has
proper generation-skipping provisions. Since 1987, this requires that your
trust provide separate exempt and non-exempt trust shares to keep track of
property that is exempt from generation skipping transfer tax (typically,
because your personal representative allocated a portion of your $1,060,000
generation skipping transfer tax exemption to the exempt property when it was
established) and property that would be subject to the 55 percent GST tax.
This is too complex for you to review without legal and tax assistance.
Suffice to say, if your trust provides that at your child's death, property will
pass directly to your grandchildren, or perhaps, that property may be
distributed to your children and grandchildren according to their needs, you
need to be certain that there is generation-skipping language in the
trust.
Under the laws of the District of Columbia, Virginia, and Maryland
it is now possible to create a "dynasty trust". A dynasty trust allows your
property to pass to children, grandchildren and more remote descendants without
need for probate -- for as long as you have descendants! The dynasty trust
takes the asset protection and divorce protection planning you did for your
children through the beneficiary controlled trust and extends them for benefit
of grandchildren and future generations.
There are complex drafting
requirements that must be satisfied to plan for the 55 percent tax on
generation-skipping transfers. This planning is well worth doing! $1 million
growing on a six percent after-tax basis will grow to more than $1 Billion in
120 years ($1,088,187,748 to be exact), while the same amount would be worth
"just" $44,000,000 if it were reinvested annually outside the trust and subject
to estate tax every 30 years at 55 percent. (This amount could be further
reduced through divorce or lawsuits.) Most of us don't have a million dollars
to leave invested for 120 years, but you get the idea!
2. Establish a
Beneficiary Controlled Trust
For all but the very smallest estates, I
recommend leaving property in an irrevocable, beneficiary-controlled trust
rather than through outright distribution. If appropriate, the child or oldest
generation can serve as sole or co-trustee of the trust, thereby giving the
child effective control of the trust. Control can be further reinforced by
giving the child (or oldest generation of beneficiaries) a broadly defined,
limited power of appointment to redistribute trust property wherever they wish,
other than to the beneficiary, his estate, his creditors, or creditors of his
estate. This gives the beneficiary the power to "disappoint" as well as appoint
assets among children, grandchildren or others -- thereby ensuring a measure of
family allegiance.
The trust should not provide any mandatory
distributions of income or confer any rights to invade principal under a "5 x 5
power". The object is to give your child use and enjoyment of the trust
property, but not ownership. Use and enjoyment is provided by permitting the
Trustee to distribute trust funds (both income and principal) to the
beneficiaries solely pursuant to "ascertainable standards" of "health,
education, maintenance and support". These ascertainable standards are words of
art that, if strictly followed, will permit the beneficiary to have access and
use of trust assets without having them includible in his estate for tax or
creditor protection purposes.
I recommend everyone establish a
co-trusteeship with a child serving as co-trustee with an independent party --
typically a Certified Public Accountant, an attorney experienced in estate
planning and trust administration, or a corporate fiduciary -- as "Independent
Trustee". The beneficiary (typically the child or oldest beneficiary) can be
given the right to remove and replace the Independent Trustee. This gives the
child or other lifetime beneficiary a high degree of control, while keeping the
property away from his creditors and outside his estate. If a higher level of
asset protection is desired, the beneficiary's right to remove the independent
trustee can be eliminated in favor of a "Trust Protector". The Trust Protector
would be given the right to remove and replace the Independent Trustees, to
transfer assets to other trusts, to relocate the trust to a different
jurisdiction to take advantage of more favorable laws, to amend the trust or to
distribute the trust corpus either outright or to another, possibly more
suitable, trust in the future.
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