In Part I of this series of articles on asset protection and risk management, we discussed some of the concepts related to family business entities. Such business entities might be operating companies or simply entities through which families consolidate management of investments. And, such business entities might be in the form of a corporation, limited liability company, limited partnership, etc. We will now touch upon trusts.
There is a common belief that traditional revocable living trusts provide asset protection. To the extent that a trust is revocable, creditors of the “trustors” – also called “grantors” – whom we will call mom and dad – will be able to reach the trust’s assets. To the extent that mom and dad’s trust is revocable, mom and dad own the trust’s assets; all the kids and successive generations have is an expectancy . . . which is nothing. We say “to the extent” because it is often the case that married couples will have joint trusts and, upon the passing of a spouse, that spouse’s portion of the trust becomes irrevocable. Whether or not the irrevocable portion of a living trust provides asset protection depends on the trust’s specific wording. If assets ultimately distribute to the next generation upon the passing of mom and dad, then creditors of that next generation will be able to reach mom and dad’s assets in the hands of that next generation. If the trust states that asset ultimately distribute to the next generation at age X, creditors of that next generation will say, “I can wait.”
A dynasty trust is a type of generation-skipping-transfer trust. While such a trust has potential tax benefits, it can also provide for the protection of mom and dad’s assets from the creditors of successive generations as they pass from one generation to the next. What kind of protection would such a trust provide? Typically, the generations below mom and dad would receive discretionary income distributions for life but not principal distributions. Principal remains in trust. If a beneficiary is subject to a creditor’s claim, the trust will specify that the trustee shall stop payments to the affected beneficiary. Once the beneficiary is no longer subject to a creditor’s claim, payments to the affected beneficiary would resume. That being said, the trustee is often given the power to make distributions for education and medical expenses if needed. Similarly, if a beneficiary has special needs, the trustee is given the power to make distributions. Such distributions are made to the provider as opposed to the beneficiary. Drafting is the key.
What makes it a “dynasty” trust is if the trust has the ability to exist in perpetuity and, thus, protect the family’s assets and achieve certain tax benefits forever. How long mom and dad’s assets can stay in trust might be limited by the jurisdiction of the trust. Under the traditional “Rule Against Perpetuities,” a trust must terminate not later than 21 years after the last living person named in trust (which might be a class of persons) dies. Some jurisdictions have modified this rule to include “or X years, whichever is longer.” Still other jurisdictions do not have such a rule. In such jurisdictions, mom and dad’s trust – if they wanted – could forever provide asset protection of their assets as they pass down through the generations. Jurisdictions that have eliminated the Rule Against Perpetuities by statute are Alaska, Delaware, Nevada, New Hampshire, and South Dakota.
These states have also adopted asset protection statutes. These statutes cross a few disciplines of law. They involve trust law, property law, corporate law, and something called civil procedure. In essence, these statutes set the rules by which a plaintiff can reach the assets of a defendant . . . or not.
But, what if mom and dad live in another state? How would the family take advantage of the laws of these other states? In short, there must be a nexus with the state. While mom and dad might live in another state, they might have assets – such as real property – in one of these states. Or, their trustee might be in one of these states. Mom and dad’s trust should include a provision that gives the trustee (or trust protector) the power to move the situs of their trust to another jurisdiction without court approval. Moreover, mom and dad’s trust would state that the governing law of the trust is of the jurisdiction in which the trust is being administered. As such, once mom and dad have passed, the trustee would change the jurisdiction of the trust to one without the Rule Against Perpetuities, and the trust – if appropriately drafted – would become a dynasty trust. The above mentioned states have made a business decision: we will craft our laws in such a way as to make our states attractive for trust administration and, as family’s move trusts to our states, trustees in our state will need to hire more people to accommodate the extra business. It’s about greater employment.
This brings up a question: why wouldn’t mom and dad name the beneficiary to be the trustee of her/his respective trust? There is a multitude of reasons. Unless the beneficiary is living in one of the jurisdictions that had no Rule Against Perpetuities, the trust must ultimately terminate and the trustee must ultimately distribute assets into the hands of a beneficiary. The family would ultimately lose the asset protection and potential tax benefits. Separately, family members often don’t have the time, the desire, or the business/tax acumen to properly administer a trust. Just consider the tax elections that a trustee might need to make. Also, if beneficiary is her/his own trustee, a court could compel the individual to make a trust distribution to a creditor irrespective of the trust’s provisions; a court might not be able to require an independent trustee to do so.
Which brings up another reason to have a trustee in one of the above-mentioned states. Perhaps the better way to phrase it is that the trustee is not in the beneficiary’s state and subject to the courts of the beneficiary’s state. Within the parlance of civil procedure, the beneficiary’s state would not have in personam jurisdiction over the trustee.
In this installment, we’ve discussed how trusts might provide asset protection for mom and dad’s assets once they’ve passed. In the next installment, we will discuss how trusts might provide asset protection for mom and dad’s assets while they are still alive.
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