The living trust is very popular in America. A living trust helps you avoid the cost and delay
of probate. You can also avoid the dangers from jointly owning assets. But a revocable
living trust wonít protect you from lawsuits.
Though a revocable trust wonít protect you, you have the comfort of knowing that you can
change or revoke your living trust as often as you can revise your will. But a living trust can
cause you to lose lawsuit protection? Several states have ruled that a homesteaded home
transferred to a living trust loses homestead protection. Similarly, assets owned between
spouses as tenants-by-the-entirety may lose creditor protection from this type of coownership
when those same assets are instead titled to a living trust.
There are trade-offs between the different ways to title assets. Without a revocable living
trust, the court will distribute your assets under your will. This can be expensive, timeconsuming,
and cumbersome. (Probate costs can consume as much as 4% of an estate and
delay estate distributions.) If you bequeath $1 million through your will, your heirs may pay
$40,000 in probate costs, and wait years for their inheritances. A living trust circumvents
the probate process. Your assets immediately transfer to your beneficiaries.
Have the best of both worlds. Title your assets to a limited partnership (to lawsuit-proof
these assets). Have your living trust (which avoids probate) own your limited partnership.
When you die, your ownership in the limited partnership immediately transfers through the
living trust to your heirs, and avoids probate. During your lifetime your assets would be
creditor-protected by the limited partnership.
Irrevocable Life Insurance Trusts
Life insurance is another important asset. Life insurance can have a substantial cash value
or death benefit exposed to creditors. Even a term policy without cash value can be a
valuable asset in that it will provide your family income and support after you are gone. But
will your beneficiaries get the death benefit, or will your creditors? Life insurance can also
pay your estate taxes and make funds immediately available to your survivors; thus
avoiding the delay and expense of liquidating other assets.
If you own a large life insurance policy, title your insurance policy to an irrevocable life
insurance trust (ILIT). An ILIT is specifically designed to own life insurance. As with other
trusts, the ILIT has a trustee, beneficiaries, and terms for distributions.
Your ILIT would own your insurance policy. The insurance policy beneficiary would be the
trust. When you die, your insurer pays the ILIT trustee, who would follow the trust
instructions and distribute the proceeds to the ILIT beneficiaries. Your estate should not be
An ILIT can be funded or unfunded. An unfunded ILITís life insurance premiums are not fully
paid. You fund future premiums (give annual premiums to the trustee, who pays the
premiums). With a funded ILIT, you transfer to the trust a fully paid insurance policy or
enough income-producing assets to pay the future premiums.
Whether you have an unfunded or funded ILIT, your policy premiums must be directly paid
from the trust. You cannot directly pay the premiums or youíll lose both the trustís tax
benefits and creditor protection.
The ILIT is irrevocable. It protects the policyís cash value, death proceeds, and distributions
from the trust to the beneficiaries. If life insurance is not fully creditor-protected by your
state laws, then an ILIT is essential for protection.
The ILIT - though sometimes important for protection - can save you estate taxes. Because
the ILIT owns the life insurance policy, the policy proceeds wonít be included in your taxable
estate, nor subject to estate taxes.
Assume you are single and die with a $3 million estate and $1 million of that amount is life
insurance. Assume that when you die you have a $2 million death tax exemption. Your
estate would then pay an estate tax on $1 million. If the estate tax is 50 %, your estate tax
would be $500,000. But your ILIT would remove the $1 million life insurance proceeds from
your taxable estate. Your estate would save $500,000 in estate taxes because you reduced
your taxable estate to zero.
The ILIT also gives you better control over policy distributions than insurance owned by you
personally. When you personally own insurance, your insurance company directly pays the
named beneficiaries when you die. An ILIT not only lets you control who receives the
proceeds, but also how and when the policy proceeds will be distributed. For instance, you
can specify that the ILIT trustee pays estate taxes and other costs (taxes due on IRAs or
other retirement plans probate costs, legal fees, other debts, etc.) before the trustee
distributes funds to the trust beneficiaries. Or you can direct your trustee to pay your
beneficiaries over a period of months or years. You can add spendthrift, anti-alienation,
discretionary distribution, and other protective provisions to protect the insurance proceeds
from your beneficiariesí creditors. The ILIT can also avoid court interference if a beneficiary
becomes incompetent. Insurance companies wonít pay life insurance proceeds to an
incapacitated beneficiary. They require court instructions. The ILIT avoids this unnecessary
Do you intend to gift money to your children? Investigate an irrevocable childrenís trust
(ICT). It can reduce taxes as well as provide protection. Property that you transfer to a
childrenís trust cannot be seized by your creditors. It also wonít be included in your taxable
estate. Income from the trust would be taxed at the childrenís lower income tax rates.
These are the reasons for the childrenís trust.
The ICT (or Section 2503 Minorís Trust) by its terms, controls the taxation and asset
protection benefits of this trust. While the trust is in effect and the beneficiary is under 21,
neither the grantors nor the childís creditors can claim the trust assets.
There is one disadvantage with the childrenís trust. When your child reaches 21, your child
can demand the trust assets. Since it is an irrevocable trust, the grantor cannot withhold
distributions from the trust. You cannot thus prevent your child from receiving the assets
that are then owned by the trust. You can only extend the trust until a later age if your
child, at age 21, consents in writing. Carefully consider whether your child (ren) at that
young age can properly handle the trust assets.
Charitable Remainder Trusts
Gifting your assets to charity may seem an extreme way to gain creditor-protection,
however, our tax laws allow you to give away your property to charity, achieve protection,
and use these same assets to generate income for you during your lifetime. For protection,
as well as the tax advantages from gifting assets during your lifetime, the Charitable
Remainder Trust (CRT) can be your answer.
Hereís an overview of how the CRT works. As the grantor, you select a tax-exempt charity
as the beneficiary of your irrevocable trust. When you create and fund the CRT, you make a
charitable donation and can claim an immediate tax deduction for the value of the assets
contributed to the trust. Although you have gifted the principal, you would be the income
beneficiary. Over your lifetime, your trust would pay you a fixed annual income. You thus
get an immediate tax deduction and future income from the donated assets.
Assume that you have $200,000 in stocks that were purchased 15 years ago for $60,000. If
you sold the stock to invest in treasury bonds, you would pay $21,000 in capital gains taxes
on the profit (15% X $140,000 gain). If your treasury bonds are worth $200,000 when you
die, your estate may then pay another $88,000 in estate taxes (although future estate
taxes are uncertain). Your heirs would inherit, after taxes, only $91,000 from the original
So, you donít sell your stocks. Instead you transfer them to a CRT. You get the same annual
income as from treasury bonds for the remainder of your life because you could be the
CRTís income beneficiary. You deduct your $200,000 donation as an immediate charitable
contribution. The income from the tax savings from your charitable deduction can buy a
$91,000 life insurance policy to cover the $91,000 that your beneficiaries would have
received had you donated your stock to the CRT. The net result: a large tax deduction this
year, the same perpetual fixed retirement income as with treasury bonds, you donate to
your favorite charity, and the donated trust assets are lawsuit-proof.
Do you have appreciated assets? Do you want a fixed lifetime income? Would the CRTís
fixed income satisfy your retirement needs (adjusted for inflation)? If so, a CRT may be a
good protective strategy for you - particularly if it can help you achieve your philanthropic
goals. Income from the CRT can be seized by your creditors, but even then there are
solutions. For example, your income can be protected through a charitable remainder
annuity trust (CRAT), if your state exempts annuities from creditor seizure. Other trusts are
variations on this theme.
Qualified Personal Residence Trusts
With a Qualified Personal Residence Trust (QPRT, you transfer your residence to the trust
and retain a tenancy for ten years. At the end of the term, your residence passes to your
beneficiaries. Your objective is to transfer your residence now at its lower value (basis),
rather than when you die and it has a greater value. The QPRT thus reduces estate taxes.
A QPRT can also lawsuit-protect your home. Your creditors can only claim your right to use
the property for the remaining term of years (or the rental value for those years). However,
your creditor cannot attach or seize the home because it would be owned by the trust. The
beneficial remainder interest can be claimed by your beneficiariesí creditors, unless your
trust includes those important spendthrift provisions. At the end of the term, the trustee
must distribute or convert the QPRT assets into an annuity. This is a more desirable
alternative in states that creditor-protect annuities.
If you are in a second (or third, fourth, or fifth marriage), the Q-TIP (Qualified Terminable
Interest Property) trust may interest you. The Q-TIP ensures that your spouse will receive a
lifetime income from the trust. The trust principal then passes to your children (or
alternative beneficiary) after your spouse dies or remarries.
Q-TIPs are common with second marriages because they preserve your assets for the
benefit of the children from a prior marriage, rather than the spouseís children or family,
who would become the probable beneficiaries of an estate bequeathed outright to a
surviving spouse. Q-TIPs can also protect a spouse when the grantor believes that the
spouse may waste the assets during the spouseís lifetime. A Q-TIP is essentially a
spendthrift trust to shelter your assets from your spouseís creditors or subsequent mates.
Income from the Q-TIP trust must be used solely to benefit the surviving spouse during the
spouseís lifetime, or the trust wonít qualify for the unlimited marital deduction. Estate taxes
on the principal are deferred until the surviving spouse dies.
A Q-TIP trust wonít protect your assets against your creditors, because the Q-TIP is a
testamentary trust. However, a Q-TIP trust can shelter your wealth from a spendthrift
spouse, a spouse who may have future financial or legal difficulties, or a spouse who may
wish to leave your money to his or her children.
The Q-TIPís trust principal will be safe from your spouseís creditors, though the income to
your spouse would not be protected. Moreover, the trust income must be distributed as
earned. The trustee cannot withhold distributions.
You can use a similar irrevocable intervivos marital deduction trust for protection. The
objective is to shift marital assets from the higher-risk spouse to the less-at-risk spouse.
This is only another form of lifetime gifting. These transfers are also subject to fraudulent
transfer claims. A spouse who makes an outright gift must understand that the transferred
assets may be lost by a surviving spouse in a later lawsuit or in divorce. It can also be lost
to the spouseís spendthrift spending.
Land trusts, widely used in Illinois, Florida, Georgia, California, Colorado, and a few other
states can partially insulate real estate against lawsuits. The land trust can own any real
estate - including the family residence. A bank is normally the trustee. The land trust
protects the beneficiariesí interest in the real estate only if the trust has the proper
spendthrift and anti-alienation provisions. As the trust beneficiary, you donít directly own
the real estate. The real estate is titled to the trustee. You own only a beneficial interest in
the trust. This interest is personal property, not real property.
Owning a beneficial interest in a land trust is not sufficiently protective. Your creditors can
seize your beneficial interest. You need more protection. One option is to title your
beneficial interest to a limited partnership, LLC or to an irrevocable trust.
Land trusts have two disadvantages. It is frequently difficult to finance land trust property
as itís necessary to temporarily re-convey the property out of the trust to its grantors or
beneficiaries to complete the financing. Also, a beneficiary desiring a Section 1031 tax-free,
like-kind exchange, must transfer the property from the trust, since a land trust is not a
beneficial interest in real property but an interest in personal property.
Privacy, not asset protection, is the land trustís major advantage. The beneficial owners
wonít appear on the public records because the property is titled to the trustee. To the
extent secrecy aids protection, the land trust can be helpful.
Nursing home costs can impoverish you as quickly as a lawsuit. Hence, the Medicaid trust.
This special purpose trust shelters assets so the grantor can qualify for Medicaid to pay their
nursing home costs. Medicaid trusts, of course, chiefly interest those who prefer to leave
their money to their children rather than spend it on their own long-term care.
A Medicaid trust is similar to other irrevocable trusts. The grantor (as an individual or
couple) transfers their assets to an irrevocable trust. However, unlike other irrevocable
trusts, the grantor can be the income beneficiary. Their children or spouse would be the
residual beneficiaries. The grantor can receive income from the trust to the maximum
amount allowed by Medicaid. But the now, asset-free grantor can qualify for Medicaid
nursing home assistance.
The Medicaid trust offers about the same asset protection as any other irrevocable trust.
Medicaid trusts prohibit using the trust assets for other health care purposes, and it also
limits the beneficiariesí income to those income limits set by Medicaid. You must create and
fund your Medicaid trust 60 months before you apply for Medicaid. Thatís its one
disadvantage: Few people can anticipate their long-term care needs that far in advance.
There are many other types of trusts out there. This is will get you familiar with some commons types - LOOP