By Abigail Neal, Scottsdale trust lawyer
When someone has created a revocable living trust and that person passes, the assets in the trust will often transfer into a trust for the benefit of the person’s descendants. One main function of this new descendant’s trust is to protect the assets held in trust from any claims that could be made against the descendant/beneficiary. This is why this type is trust is often referred to as an asset protection trust. Potential claims include claims made by creditors (car accident liability for example) and predators (ex-spouses, con-men, etc.). A descendants asset protection trust acts like an insurance policy against those claims. We also like to call this an inheritance protection trust.
Like everything in the law, there is no guarantee that the trust will be 100% effective. However, it does provide a significant barrier between the descendant/beneficiary’s assets and the potential creditors/predators. There are a number of factors that can either strengthen or weaken that barrier.
Some lawyers take the view that the barrier can be strengthened by naming a corporate fiduciary or trust department as the trustee of the descendant’s trust. However, corporate fiduciaries come at a cost and a loss of some of the descendant/beneficiary’s control. Conversely, some other lawyers believe that a beneficiary may act as the trustee of his or her own trust without weakening that barrier at all. We often see parents who choose the best of both worlds solution: allow the beneficiary to act as the trustee of his or her own trust, but require that the beneficiary act with an independent trustee. In many cases this independent trustee might be an attorney, CPA, or corporate fiduciary.
Another option that many clients prefer is to appoint a distribution trustee (who likely also qualifies as an independent trustee). A distribution trustee only acts if a third party attempts to take the assets held in the trust. This option allows the beneficiary to act as sole trustee of his or her own trust and eliminate the problems that may stem from naming a co-trustee.
If there is an independent co-trustee appointed, the role of that trustee may be limited. Often the descendant/beneficiary will consolidate all of the assets held in trust into one account. When the account is opened, a trust certification or certificate of trust is created which details the pertinent provisions of the trust for the financial institution. In this certificate the descendant/beneficiary can name him or herself as the sole trustee of the trust. At that time, the descendant/beneficiary and his or her independent trustee may also authorize that all income produced by the trust assets be transferred directly to the beneficiary. However, we recommend that if any principal is going to be distributed from the trust, both trustees should approve the distribution prior to it being made. Another thing to note is that the descendent/beneficiary typically has the authority to remove and replace this co-trustee. However, the successor trustee appointment must be made in writing. The descendant/beneficiary typically also has the right to appoint a successor trustee if the beneficiary is unable to serve as trustee.
There is an important tax reason for transferring the trust income directly to the beneficiary. Trust income is taxed at a higher rate that many individual’s income tax rate. However, if the trust income is distributed to the descendant/beneficiary, the income is not taxed to the trust. However, it is important to note that even if the trust is not required to pay any income tax (since all of the income was distributed to the descendant/beneficiary), the trust is still a tax reporting entity that is required to have its own tax identification number and must file annual income tax returns. Given these potential tax consequences, we advise every beneficiary to consult with a qualified accountant before structuring the trust account or taking distributions from the trust.
One should also take note of the provisions in many trusts relating to powers of appointment and the appointment of successor trustees. A descendant’s asset protection trust is designed to last for the life of the beneficiary and often gives the beneficiary the power to delegate who should receive the assets remaining in trust. This power is referred to as a power of appointment. In order for the beneficiary to exercise this power of appointment, he or she must create a will or revocable living trust of his or her own exercising the power of appointment. If the beneficiary does not do this, then the assets remaining in trust will typically be distributed to the beneficiary’s descendants or siblings. The assets would remain in the descendant’s asset protection trust under the same provisions as the original trust, with a provision that is typically included to allow the new beneficiary to step into the role as trustee upon reaching a certain age.
The power to appoint the assets remaining in trust is usually a “limited” power, meaning that the beneficiary cannot exercise the power to appoint the assets to him or herself, his or her estate or creditors of the estate from the “limited share” of the trust. Since the power to appoint is limited, the assets in the trust are not included in the beneficiary’s estate. If the beneficiary has an estate that may be subject to estate taxation, the potential savings of removing the trust assets from the beneficiary’s estate could be substantial.
The power to appoint is generally a limited power, that is, the beneficiary may not exercise this power of appointment to appoint to herself, her estate, her creditors, or the creditors of her estate from the “limited share” of her asset protection trust. Because the power is limited the assets in the beneficiary’s trust are not included in the beneficiary’s estate at the time of the beneficiary’s death. Depending on the size of the beneficiary’s estate, the potential estate tax savings from this is measured in the tens of thousands of dollars.
While this article explains the typical provisions found in asset protection trusts, every trust is different and custom tailored to the trustmaker’s own wishes and desires.
Scottsdale trust attorney Abigail Neal can create your descendant’s asset protection trust as part of a comprehensive estate plan. Learn more about Powers & Neal’s estate plans, and call (480) 699-7992 today to get started.