Getting Clear on Creditor Protection: The Limitations of the Revocable Living Trust
by Robert A. Hull
People often believe that if they set up a revocable living trust, and put their assets into the trust, their assets are protected from creditors.
While a revocable living trust can provide numerous benefits – namely, the distribution at death of one’s property without court supervision and, possibly, substantial tax advantages – such a trust does not provide creditor protection.
General Rule of Thumb: The ability of a creditor to reach your assets is directly proportionate to how much control you can exercise over those assets (and/or whether you are a beneficiary of that trust, in which case the trust is called a “self-settled” trust). The greater control you have over your assets and/or benefit you derive from your assets, the greater chance a creditor can reach those assets.
If you are the trustee of your revocable living trust, you are able to effectively control your assets as much as you can without such a trust. You can amend or revoke the trust (hence, the name “revocable” trust) and withdraw assets from the trust, at will. Thus, since you have the same degree of control over your property, creditors may access the trust’s assets almost as easily as they can access your assets which are not in such a trust.
On the other hand, the less control you have over those assets, the less chance a creditor can reach those assets.
In the most obvious case, if you give away assets, you no longer have control of those assets. Hence, a creditor cannot normally reach them (unless there are mitigating circumstances such as the transfer was a fraudulent attempt to evade those creditors or a preferential transfer prior to a bankruptcy filing, etc.).
However, you can achieve some protection from creditors and still maintain a degree of control over your assets for a period of time, even though you are effectively giving your assets away.
Three Ways to Better Protect Your Assets from Creditors
1. Irrevocable Trusts: Certain people set up “irrevocable” trusts for the benefit of their children, etc. With these trusts, you are making a present gift of property, the bulk of which the beneficiary may receive at your death, or some other time in the future (note: the gift needs to qualify as a present interest to be eligible for the gift tax annual exclusion).
However, as trustee, you can still manage the property in the irrevocable trust until that future time, although you will not want to hold powers which will cause the trust to be included in your taxable estate at your death. This is especially helpful when gifting business or real property interests. Remember though, that you cannot modify these trusts, or remove property from them, without complying with state law and without risking its tax treatment, and in some cases exposing the trust to taxation. Hence, your creditors cannot normally reach such property (except if there are mitigating circumstances, as mentioned above).
2. Gifts: In addition, you may wish to make a gift to heirs, but asset protection of such heirs may be a consideration (e.g., minimizing a child’s exposure to divorce, tax problems, professional liability and general creditor problems). Protection may be achieved to some degree by leaving the beneficiary’s bequest in trust, rather than gifting assets outright.
3. Business Structures: You may set up a business entity structure which can make it more challenging for creditors to reach your assets. But, setting up and maintaining such entities, and also irrevocable trusts, involves some time and expense (e.g., in certain cases, the filing of annual income tax returns, payment of annual fees, substantial legal and accounting fees, etc.).
There are many terrific reasons for executing an estate plan, including a trust and a pourover will. However, if creditor protection is an important consideration for you, you need to carefully implement the right devices to minimize the risk of creditors successfully coming after your property.