Asset protection trusts

In short

I once sat with a man who had built a company from a garage, and he asked me a plain question over coffee: how do I keep what I built if somebody sues me someday? If you are holding a large estate, you have probably asked the same thing. An asset protection trust is one answer, though it works only in narrow conditions. The person who sets it up must do so while solvent, long before any claim is in sight. The trust has to be managed by an independent trustee, and the person who funds it gives up real control. A court can undo the transfer if it was made to dodge a known creditor. The trust does not lower income tax or estate tax by itself. So the best first step is a careful talk with a trust lawyer in the state you have in mind.

The whole of it

What it is

A friend of mine once said that a good fence does not make you a bad neighbor, it just keeps the cattle where they belong. An asset protection trust is a bit like that fence. It is a legal arrangement where a person, called the grantor, moves property to a trustee. The trustee is a person or company that holds the property and manages it under written terms. The grantor can still be named as one of the people who may receive money from the trust.

That last part is what makes these trusts unusual. In an ordinary trust you set up for yourself, a creditor can generally reach what is inside, because you are both the giver and the receiver. An asset protection trust, often called a self settled trust, is built under a state law that says a creditor mostly cannot reach it. Some states have passed such laws. Others have not. Several offshore countries have their own versions as well.

The trust does not make a person judgment proof. It sets up a hurdle that a creditor must clear, and the height of the hurdle depends on the state, the facts, and the timing. Plenty of people hear the words asset protection and picture an unbreakable vault. It is closer to a locked gate with a long list of rules about who may be turned away.

How it works

If you are thinking about one of these, you have probably wondered how the steps fit together, and the order of events matters more than the paperwork. The grantor signs the trust document and names a trustee. Each state that allows these trusts sets its own rules about the trustee, and those rules differ from one state to the next. Some require a trustee who lives in the state or is a trust company there. Others focus on where the trust is run or what ties it has to the state. The grantor then transfers assets into the trust, such as cash, brokerage accounts, or shares in a family business.

Once the assets are in, the trustee holds legal title. The trustee decides when and whether to make payments to the grantor. That discretion is the key. If the grantor could force the trustee to pay, a creditor could usually step into the grantor's shoes and force payment too. So the grantor keeps a hope of receiving money, not a right to it.

Then there is the waiting period. Most of the state laws set a window, after the transfer, during which a creditor can still challenge it. That window runs for a stated number of years that differs from state to state. After it closes, a challenge gets much harder. If a claim shows up before the window ends, or if the transfer looks like an attempt to cheat a creditor who already existed, a court can unwind it.

Courts look hard at intent. Every state has a law against fraudulent transfers, which means moving property to put it out of a creditor's reach. A transfer made when no claim was in sight, by a person who stayed comfortably solvent, stands on far firmer ground. A transfer made after a lawsuit lands looks like a runaway.

The numbers, and where to find yours

I have noticed that people weighing a trust like this often want a single figure to hold onto, and I wish I could hand one over. The honest answer is that the figures that matter come from the law of one state and from the grantor's own balance sheet.

The first number is the waiting period before a creditor challenge is cut off. It is set by the state statute that creates the trust, so ask your lawyer to point you to the exact section. The second number is the gift tax picture. Moving assets into a trust can count as a gift, and the federal lifetime exclusion is the current figure, which the official source publishes each year. The Internal Revenue Service publishes that figure each year, and you can read it on irs.gov. Whether a given transfer is a completed gift depends on how the trust is drafted, which is why the drafting matters so much.

The third number is cost. Lawyers, trust companies, and annual trustee fees all add up, and quotes differ widely from one firm to the next. Ask for fees in writing before you sign anything. The fourth number is the size of the assets you plan to keep outside the trust. A sensible plan leaves enough in your own name to pay your bills and your known debts, since a grantor who strips out everything looks like a person hiding from creditors.

A worked example

Let me tell you about a man I will call Walter Brandt. Walter runs a regional chain of equipment dealerships, and he is sixty one. His net worth is about $48,000,000. He has no lawsuits, no unpaid debts, and a healthy bank account. His lawyer tells him that a surgeon or business owner in his spot faces real claim risk over a lifetime, from accidents, contracts, or a guarantee he once signed.

Walter decides to fund a self settled trust in a state that allows them. He keeps $18,000,000 in his own name for living costs, his business, and his known obligations. He moves $30,000,000 into the trust. Check the math: $48,000,000 minus $18,000,000 leaves $30,000,000, and $18,000,000 plus $30,000,000 brings him back to $48,000,000. So about 62 percent of his wealth goes in, since $30,000,000 divided by $48,000,000 is 0.625.

Now suppose the state sets a two year window. Walter funds the trust on January 1 of year one. A creditor with an existing claim could challenge the transfer until January 1 of year three. If a lawsuit against him begins in year five over an accident he did not plan, the creditor faces a much harder case than in year one. Walter was solvent, he was honest about it, and nothing was pending.

Now picture the reverse. Walter gets a demand letter on March 1 and funds the trust on March 15. That looks like running. A court can set it aside, and he may end up worse off than before, with legal fees on top.

Where it goes wrong

I have watched good people make a bad call here, so let me say it plainly. The first trouble is timing. A trust funded after trouble starts is easy to attack. Lawyers who have fought these cases say so often.

The second trouble is control. If the grantor treats the trust like a personal checking account, a judge may call it a sham. The trustee has to be real and independent. The grantor must not give orders and expect them followed.

The third trouble is the court that hears the case. A creditor may sue in a state with no such law, and that court might refuse to honor the trust. A court has to decide which state's law applies, and the answer depends on the facts of each case. Offshore trusts raise their own problems, including cost and reporting duties to the Internal Revenue Service. A judge may also order a grantor to bring assets home. A grantor who refuses can face civil contempt, which can include jail.

The fourth trouble is divorce and support claims. Many state laws carve out exceptions for a spouse or a child owed support. A trust may not shield against those at all.

The fifth is tax. The trust may be treated as the grantor's own for income tax, so the grantor may still owe the tax. It may also stay inside the grantor's estate. That is a design choice, and a good lawyer will walk through it. Slow down here. Mistakes are costly.

Questions to answer before you leave this page

Are you solvent today, and can you honestly say no claim is pending or on the way? Which state's law would govern the trust, and who would serve as the independent trustee? How long is the waiting period in that state, and what exceptions does the statute list for spouses, children, and certain taxes? How much will you keep in your own name so your bills and known debts stay covered? Have you asked a trust lawyer whether the transfer counts as a completed gift, and what that does to your federal gift tax filing? What will the trust cost to set up and to run each year, and is that cost worth the protection it gives you? And have you asked yourself whether the trust matches a real worry, or only a passing fear?