Most states prohibit so-called self-settled asset protection trusts, or a trust you establish yourself for your benefit, yet which purports to protect the trust assets from creditors. However, there is a trend among the states to allow these types of trusts, and several states have recently changed their laws to permit them including Alaska, Delaware, Nevada, Rhode Island, South Dakota, and Utah and a few others.
With a domestic self-settled asset protection trust, you irrevocably transfer assets to the trust and name yourself as a beneficiary to receive distributions within the discretion of an independent trustee. You may, however, retain certain rights, including the right to remove and replace the trustee as long as the replacement trustee is also independent and not a related or subordinate party as defined in the Internal Revenue Code. By retaining a limited power to appoint the trust assets to specific family members at your death, the transfer is incomplete for gift tax purposes and therefore you are not required to file a federal gift tax return. If the trust is designed as incomplete for gift tax purposes, the trust remains part of your estate but the assets should remain free from the claims of your creditors. If designed as a completed gift for tax purposes, others will be the primary beneficiaries but you might still entitled to receive discretionary needs benefits should you be without sufficient resources to maintain your lifestyle.
The self-settled asset protection trust laws vary from state to state and, therefore, there may be advantages to selecting one state’s laws over another in your particular circumstances. Fortunately, you can elect to have your trust governed by a particular state’s statute as long as you meet the requirements of that statute, which typically include that the trust assets be located within that state and managed by a local trustee. Note that self-settled asset protection trusts are only effective for future creditors, as the fraudulent transfer laws of all states prohibit transfers to avoid existing creditors. Also, the trust must be in existence for at least 10 years to protect you against creditors in bankruptcy.
A revocable trust provides no asset protection for the trust maker during his or her life. Upon the death of the trust maker, however, or upon the death of the first spouse to die if it is a joint trust, the trust becomes irrevocable as to the deceased trust maker’s property and can provide asset protection for the beneficiaries, with two important caveats. First, the assets must remain in the trust to provide ongoing asset protection. In other words, once the trustee distributes the assets to a beneficiary, those assets are no longer protected and can be attached by that beneficiary’s creditors. If the beneficiary is married, the distributed assets may also be subject to the spouse’s creditor(s), or they may be available to the former spouse upon divorce.
Trusts for the lifetime of the beneficiaries provide prolonged asset protection for the trust assets. Lifetime trusts also permit your financial advisor to continue to invest the trust assets as you instruct, which can help ensure that trust returns are sufficient to meet your planning objectives. The second caveat follows logically from the first: the more rights the beneficiary has with respect to compelling trust distributions, the less asset protection the trust provides. Generally, a creditor steps into the shoes of the debtor and can exercise any rights of the debtor. Thus, if a beneficiary has the right to compel a distribution from a trust, so too can a creditor compel a distribution from that trust.