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Using Trusts to Protect a Beneficiary’s Inheritance From Creditors in the Era of Tax Reform

By Jacqueline L. Messler

Now that the Tax Cuts and Jobs Acts has passed and the estate tax exemption has been doubled, trusts are no longer advantageous, right? And perhaps, we can look to terminate existing irrevocable trusts, as discussed in Fixing Irrevocable Trusts. The answers are not so simple.

First, revocable trusts have many uses in estate planning, other than to save on taxes, including:

  • Probate Avoidance and Savings. Keeping the estate of the trust creator (the “Settlor”) outside of probate. Going through probate means that the administration of a decedent’s estate will be subject to the oversight of a probate court. A properly coordinated trust plan will avoid probate;
  • Management During Lifetime Incapacity. In the case of the Settlor’s incapacity, the successor Trustee will often have an easier time managing the assets titled in the trust compared to a financial agent under a durable power of attorney managing assets outside of the trust; and
  • Accessibility. Upon the Settlor’s death, the successor Trustee will often be able to access the trust assets much faster than in a probate, which is important for expenses like the funeral bill, which tend to come up shortly after death.

In addition to the reasons mentioned above, one specific type of trust can be particularly beneficial – a trust that generally protects a beneficiary’s inheritance from divorce and other creditors.

What does this trust look like? A typical protective trust generally looks like this: After someone’s death, once the beneficiary’s share of the estate is determined, rather than cutting a check for that beneficiary’s share, the share will instead be held in a separate trust for the benefit of the beneficiary. The beneficiary can be the Trustee (i.e., the money manager) of his or her own trust, or the Trustee could be an independent party, such as a bank or trust company (which often provides even better creditor protection). The Trustee makes distributions to the beneficiary, or on the beneficiary’s behalf, for the beneficiary’s health, education, support, and maintenance. The trust can provide that the beneficiary may make gifts from the trust to the beneficiary’s descendants (which can be used, for example, to pay for college education for the beneficiary’s children). At the beneficiary’s death, the trust can, but need not, give the beneficiary the right to say where the remaining assets are distributed upon the beneficiary’s death. This “power of appointment” often includes the beneficiary’s spouse, descendants, and charities. If the beneficiary does not exercise the power of appointment, the trust will provide how the remaining assets are distributed, often to the beneficiary’s children (either outright, or in a similar, protective trust).

This type of trust is also known as a dynasty or generation-skipping trust. A generation-skipping trust does not mean that you must skip your children in favor of your grandchildren. Rather, the trust can benefit your children, but stay in trust for the benefit of your children, grandchildren, and further descendants. The name “generation-skipping” comes from the fact that the trust can potentially protect the trust assets from taxation for many generations. Under the assumption that the estate tax exemptions will continue to stay high (although the current exemptions will sunset and revert back to pre-2018 levels after 2025 unless Congress extends the current provisions), the primary focus of estate planners for clients who fall below the new estate tax exemption threshold has shifted away from taxes and towards creditor protection.

One reason why these protective trusts provide protection against the beneficiary’s creditors is that they contain a “spendthrift” provision. A spendthrift provision means that the beneficiary is unable to give away his or her interest in the trust. For example the beneficiary could not pledge the trust assets to secure a loan. Further, creditors often cannot access the trust assets because the beneficiary does not own the trust assets. Rather, the beneficiary can benefit from the trust assets by receiving distributions (although once a distribution is made, the creditor will likely be able to reach the amount of the distribution).

By maintaining the assets in a trust, rather than distributing the assets outright to the beneficiary, the assets continue to be separate and identifiable. This factor will be very important in the case of the beneficiary’s divorce because the trust assets have not been comingled and transformed into marital property.

One might think of creditor issues to be those caused by risky investments, gambling, drug issues, and the like. Most often though, factors such as a major medical issue forcing someone into bankruptcy, or a failed business, result in a beneficiary’s creditor problems. While these trusts are not an absolute guarantee that the assets will be protected from the beneficiary’s creditors, they provide much more protection than if the assets had been distributed to the beneficiary outright.

This type of planning might sound inflexible. However, under the Wisconsin Trust Code, which was completely updated in 2014, we can name a trust protector in the trust, which can add a lot of flexibility to cover future, unexpected events. A trust protector is essentially someone who is given specific powers. Example powers include the ability to add beneficiaries, to remove beneficiaries, to change administrative provisions in case of future changes to the tax laws, to postpone distributions if the beneficiary is disabled, is going through a divorce, or is going through a bankruptcy, etc.

In summary, trusts offer benefits far beyond minimizing estate taxes. A protective trust can protect your estate from the creditors, including a divorce, of the beneficiaries inheriting the estate.

If you have any questions regarding this article, please contact your Davis & Kuelthau attorney, the author noted above or our Trusts, Estates and Succession Planning practice co-chairs linked here.